1. Money

The Stock Market's Risk Premium

What Does It Mean and How Do You Calculate It?

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Should you invest in stocks or bonds? This is the basic question all investors ask within the context of a changing economy and/or stock market.

The answer often revolves around the relative anticipated reward and the amount of risk the investor is willing to take.

Historically, stocks outperform bonds, but only over periods exceeding 10 years. In the short term, bonds may outperform stocks especially when the market is volatile or taking one of its periodic dives.

You can compare the anticipated return of stocks against the relative safety of bonds. If you want absolute safety and are willing to settle for little or no return, then U.S. Treasury bonds, bills and notes are the way to go.

So, how do you determine the relative risk and expected reward from stocks? One place to start is to calculate the risk premium for the stock market.

The risk premium is how much stocks should return over a risk-free investment. This premium return is what investors need to compensate for the risk of investing in stocks, as opposed to the return from the risk-free investment.

One simple way to calculate the risk premium of the stock market is to take the average return of the stock market (using the S&P 500 Index) and subtract the average return over the same period for the risk-free investment (using the return of the 3-month Treasury Bill).

For example, if the average return of the S&P 500 Index for the past 12 months has been 7.5% and the average return of the 3-month Treasury Bill has been 2%, then the risk premium for the market is 5.5%.

Using this simple formula, an investor could conclude that stocks should earn at least 5.5% more than the risk-free investment. If an individual stock poses more risk than the market as a whole, the investor would conclude that the stock should return more than the market premium.

Of course, it is not that simple. The criticism of this method is that the investor has no way of knowing whether the relationship between the performance of the stock market and the return from the risk-free investment will remain the same in the future.

As they say, past performance is no guarantee of future results.

There is an ongoing debate between the academic community and stock market analysts about how to calculate the risk premium of the stock market and what it means.

While the debate is interesting, I am not sure it has much relevance for the individual investor, unless you have a very large portfolio.

The value of an accurate measurement of the market's risk premium is important in asset allocation of large portfolios.

For the individual investor, the risk premium of the stock market is used in calculating an estimated return of an individual stock. While this is an important factor, you must remember that there is no sure way to find the correct market risk premium.

The academic side often comes up with a smaller number than market analysts, however neither side has such a compelling argument that it is the clear winner.

If you use the simple formula above, your answer is no better or worse than anyone else can calculate.

It is important to remember that any financial calculation that relies on an estimate is only as good as that estimate. Both the academic and industry stock market risk premium calculations rely on estimates.

The risk premium of the stock market is, at best, a guideline. It falls into the same group of financial calculations that provide hints about stock market activity, but do not give investors definitive guidance on the best course of action.

Investors still need to use common sense and multiple inputs to make decisions about investing in the stock market.

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