Investors love the rewards that come with finding a good investment, but they hate the risk they must absorb to find that investment. The tolerance for risk is a subjective thing, but it can be given a number. That number is called the risk premium, and it indicates the kind of “wiggle room” an investor is comfortable with when it comes to an investment. Risk premium sounds like a complicated term, but it is actually a very simple indicator any investor can use to determine their comfort level with an investment.
The expected return on an investment is an estimate based on past performance. In the securities world, any company or person who issues an investment is very careful to make it clear that past performance is not any promise of future returns. That is the risk that investors assume. For example, an investment might be rated to have an expected return of 10 percent per year, but that does not mean that you will make 10 percent. You could make 10 percent, or 20 percent or zero percent. You could make a big profit, or you could lose everything.
Most securities formulas have what is referred to as a baseline return. This is a real number that has remained steady and stable despite changes in the markets. For example, United States treasury bonds tend to have a very stable rate of return because they are backed by the U.S. government. When investors want a baseline return number, they will often use the expected return for U.S. treasury bonds. Since we are talking general numbers, it is possible to use the expected return of a bond to calculate the potential return on a stock or other investment.
Calculating Risk Premium
Let’s say that you choose the U.S. treasury bond as your baseline return and it gives an expected return of five percent. Now let’s say you are looking at an investment that has an expected return of 10 percent, and it is not a treasury bond. Your formula for risk premium would be:
Risk Premium = Expected Return – Baseline Return
In this case, the calculation would be:
10 percent – 5 percent = 5 percent
Utilizing Risk Premium
For some investors, the higher the risk premium, the better the investment. A high risk premium means that there is a lot more wiggle room in the return and that indicates a lower risk. There are other formulas you would use to calculate your expected return, but the risk premium is what you would use to determine if an investment is in your comfort zone or not.
Investors have a lot of formulas they use to determine how they will invest their money, and one of the most common formulas is risk premium. This is a simple little calculation you can use to determine whether or not an investment is right for you. Many investors set a risk premium range they are comfortable with and base their decisions on where in that range the risk premium falls for a specific investment.