If you assume the risk of investing in a stock, you should expect a reward that is appropriate to the risk.
The problem with the risk and reward relationship is that the reward is always a “potential” reward. If it were certain, there would be no risk.
Still, investors need a way to figure out way that reward should be. Fortunately, there is a quick way you can get a reading on an investment's potential reward to see if it is in line with the risk you are taking.
First Step
The first step is to determine the “risk-free” return available in the market. This is an investment you could own that is without risk and serves as a baseline for your measurement.Many investors use U.S Treasury Bonds for this benchmark, since they are backed by the “full faith and credit” of the U.S. Government.
If you can earn a risk-free return from Treasury bonds of five percent, that becomes your baseline. Any investment with risk must return more than five percent.
The amount the investment returns over five percent is known as the risk premium.
For example, if you are looking at a stock that with an expected return of 11 percent, the risk premium is six percent (11% - 5% = 6% risk premium).
Enough
Is that enough of a premium for the risk that this particular stock may not achieve the return you expect?For a well-established, large-cap stock, it probably is. However, for a young, small-cap stock, that may not be enough of a risk premium to justify the risk you are taking with the investment.
