How to Calculate Risk Premium

Risk and reward. They are two sides of the same coin – at least that’s the way it’s supposed to work for stock investors.

If you assume the risk of investing in a stock, you should expect a reward that is appropriate to the risk.

The problem with the risk and reward relationship is that the reward is always a “potential” reward. If it were certain, there would be no risk.

Still, investors need a way to figure out way that reward should be.

Fortunately, there is a quick way you can get a reading on an investment's potential reward to see if it is in line with the risk you are taking.

First Step

The first step is to determine the “risk-free” return available in the market. This is an investment you could own that is without risk and serves as a baseline for your measurement.

Many investors use U.S Treasury Bonds for this benchmark, since they are backed by the “full faith and credit” of the U.S. Government.

If you can earn a risk-free return from Treasury bonds of two percent, that becomes your baseline. Any investment with risk must return more than five percent.

The amount the investment returns over two percent is known as the risk premium.

For example, if you are looking at a stock that with an expected return of 11 percent, the risk premium is nine percent (11% - 2% = 9% risk premium).

Enough

Is that enough of a premium for the risk that this particular stock may not achieve the return you expect?

For a well-established, large-cap stock, it probably is.

However, for a young, small-cap stock, that may not be enough of a risk premium to justify the risk you are taking with the investment.

Conclusion

This simple test is certainly not all the analysis you should do and there could be other factors involved. However, you should always ask yourself if the risk premium for a particular investment makes it worth risking your money on a particular stock (or any investment).