The idea of risk premium is that investors have a safe place to put their money (U.S. Treasuries), so any investment that carries more risk should also offer a premium return.
For example, if we assume that investors can earn 4 percent with absolute safety, what premium above that should they insist on from a stock?
Many investors suggest that, at a minimum, you should expect a risk premium of 4 percent. This would give you a minimum expected return of 8 percent.
That minimum 4 percent risk premium would be assigned to the most stable and trustworthy companies - the bluest of the blue chips, if you will.
Level of Trust
Companies that fall short of this level of trust would carry a higher risk premium. In other words, investors would expect a higher potential reward for the additional risk they were assuming.While topnotch companies may only carry a 4 percent risk premium, a small high tech company may carry a much larger risk premium.
Investors demand a higher potential return from younger and smaller companies with unproven business strategies. They could demand a return of 12 percent or much higher.
Do these risk premium percentages still make sense during turbulent markets?
Market Stressed
Perhaps not. When the market itself is stressed, stock prices are often distorted (either up or down) and an accurate risk premium may be hard to determine.In down markets, it may be difficult to achieve the necessary returns to make the risk premium formulas work.
Stock prices often fall across the board and that distorts whether the company is producing the level of returns necessary to meet the risk premium requirements.
Likewise, in an active up market prices may be overstated, which equally distorts true growth behind price bubbles.
Investors should consider the influence of market conditions when calculating risk premium. Be prepared to lower expectations in down markets and guard against over-exuberance in up markets.
