A risk premium is the amount of return one needs to realize before taking a chance with an unsecured investment versus a guaranteed investment. This is a very important factor investors consider when choosing how best to allocate their limited resources. Of course, in many cases, this premium is theoretical. Very few may actually have a set risk premium in their minds, or at least refer to it in those terms.
This risk premium can also be described as the return one expects to make on the market security, versus what kind of return they can make on a more risk-free investment. In the case of a risk-free investment, this usually means an interest rate paid on something like US Treasury bonds or some other sort of guaranteed investment. Of course, even these investments are not guaranteed completely. If there was a catastrophic failure of the financial institution or federal government in the case of treasury bonds, all would be lost. Of course, any cash assets would quickly become worthless under those circumstances.
For stocks, the return on investment is calculated by looking at two factors -- the dividend payout, which can come as often as every quarter, along with the capital gains. The capital gains are only realized when a stock is sold. Many may not factor in both issues when looking at a risk premium. Where stocks are considered, this is sometimes referred to as equity or stock risk premium.
For bonds, the risk, sometimes referred to as the bond risk premium, can be determined simply by looking at the difference in interest rates between what the bond will yield and what the guaranteed investment would be. In nearly all cases, the bond will yield a higher interest rate. Otherwise, there would be no reason for any investor to consider them as an option.
To calculate a risk premium, one simply needs to consider the return on investment of a guaranteed investment versus a more risky one. For example, if a US Treasury bond yields 3 percent and the expected rate of return on a stock is 8 percent, the risk premium would be 5 percent -- eight minus three. Whether this is worth the risk is a question for the individual investor, who may also seek the advice of an investment adviser before making such a choice. The amount of risk someone is willing to take may change depending on investment goals or life circumstances, therefore this can be relatively fluid.
