How to Calculate Risk Premium

Calculating Risk Premium and What It Means to Your Investment

Risk and reward. They're two sides of the same coin in almost every situation, and that's the way it's supposed to work for stock investors, too. There's a clear correlation between the two: When you assume the risk of investing in a stock, you should be able to expect a reward that is commensurate with the risk. The greater the risk, the more you should earn. 

The problem with the relationship between risk and reward is that the reward is always a potential reward.

It's not in the here and now, and it's not carved in granite. If it were certain, there would be no risk. That element would be taken out of the equation. 

So where does this leave investors? They need a way to figure out what their reward should be so they can invest accordingly. Fortunately, there is a quick and easy way you can get a reading on an investment's potential reward to see if it's in line with the risk you're taking. 

The First Step

The first step is to determine the "risk free" return that's currently available in the market. This is an investment you could own that is without risk and that serves as a baseline for your measurement. Many investors use U.S treasury bonds for this benchmark because they're backed by the full faith and credit of the U.S. government.

If you can earn a risk-free return of 2 percent from treasury bonds, that becomes your baseline. That means any investment with risk must return more than 5 percent to be worthwhile.

The amount the investment returns over 2 percent is known as the risk premium.

Here's an example. If you're looking at a stock with an expected return of 11 percent, the risk premium is 9 percent: 11 percent less 2 percent equals a 9-percent risk premium.

Is It Enough?

Is 9 percent enough of a risk premium for the risk that exists that this particular stock might not achieve the return you expect?

It probably is, at least for a well-established, large-cap stock. But what about a young, small-cap stock? That might not be enough of a risk premium to justify the risk you're taking with the investment.

Conclusion

This simple test is certainly not the only analysis you should do, and there could be other factors involved. The lesson here is that you should always ask yourself if the risk premium for a particular investment makes it worth wagering your money on a particular stock, or any investment for that matter.

And there's also a factor that's not quite quantifiable, at least numerically—your own aversion to or tolerance for risk. A 9-percent risk premium might be more or less than you can comfortably stomach. And if investing were an exact science, we'd all be rich.

Note: Always consult with a financial professional for the most up-to-date information and trends. This article is not investment advice and it is not intended as investment advice.