How to Calculate Risk Premium

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. When you assume the risk of investing in a stock, you should be able to expect to get a reward that's commensurate with the risk of holding the investment. The greater the risk, the more you should earn to compensate. 

The problem with the relationship between risk and reward is that the reward is always a potential reward. The rewards for investing don't take place in the present, and they're never completely guaranteed.

Investors need a way to estimate what their reward, or earnings, on an investment should be so they can invest accordingly. There's a quick and easy way that you can get a reading on an investment's potential reward if you'd like to assess the potential risk you're taking on. 

The Risk-Free Return

First, determine the "risk-free" rate of return that's currently available to you in the market. This rate needs to be set by an investment you could own that has no risk of default or failure, and that can serve as a baseline for your risk-free return measurement.

Many investors use U.S. Treasury bonds for this benchmark because since they're backed by the full faith and credit of the U.S. government, the likelihood of default is very, very slim and the return is virtually guaranteed.

If you can earn a risk-free return of 2% from Treasury bonds, that will become your baseline. This means that any investment you take on that has risk must return more than 5% in interest, capital appreciation, or both, in order to be worthwhile. Any amount that the investment returns over the 2% risk-free baseline is known as the risk premium.

For example, the risk premium would be 9% if you're looking at a stock that has an expected return of 11%. The 11% total return less a 2% risk-free return results in a 9% risk premium.

Is It Enough?

When choosing investments for your portfolio, ask yourself if 9% is significant enough of a risk premium for the risk associated with a given asset. The particular stock you're considering might not achieve the return you expect.

The investment may perform well, but its return might not include enough of a risk premium to justify the risk you're taking with the investment, especially for young, small-cap stock investments.

Conclusion

This simple test is not the only analysis you could or should do and there might be other factors involved in the investment's performance. 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 that particular stock—or any investment for that matter.

There's also a factor that's not quite quantifiable, at least numerically. Your own aversion to or tolerance for risk should be considered as well. You might require much more than a 9% risk premium to take certain investments, or you might only feel comfortable with investments that are very safe, conservative and because of this, have a minimal risk premium. Knowing your risk tolerance is an important part of successful investing.