When investors make risky investments, they naturally want to earn higher returns to compensate for the additional risk taken. The concept of a ‘risk premium’ captures this idea – it refers to the extra return above the risk-free rate that investors demand for holding risky assets. Proper assessment of risk premiums is crucial in areas like portfolio management, asset valuation, and capital budgeting. In this article, we will explore the logic behind risk premiums, their role in investment analysis, and factors that influence their level.
Investors are generally risk averse and demand compensation for risk
A key tenet in finance is that investors are risk averse – they dislike uncertainty and variability in returns. This makes intuitive sense, as people generally prefer stable, predictable outcomes. When evaluating risky investments then, investors naturally demand a premium – an incremental expected return above the risk-free rate – to compensate for the extra risk. The market ultimately determines appropriate risk premiums through the interactions of buyers and sellers. An asset with more risk has to offer higher potential returns to attract investors and compensate them for bearing that risk.
Higher premiums required for assets with more variability in returns
Not all risks are created equal in the minds of investors. Generally, the higher the variability and uncertainty in an asset’s returns, the higher the risk premium demanded. For example, equities exhibit more return variability than bonds, so stocks command a larger premium over the risk-free rate. Within the stock market, small-cap stocks have greater earnings volatility than large-cap stocks, warranting a higher expected return. The same logic applies across other asset classes – junk bonds require a greater premium versus investment grade bonds due to higher potential defaults.
Macroeconomic conditions and investor sentiment influence premiums
While an asset’s inherent risk characteristics determine its baseline risk premium, the actual premiums can fluctuate over time depending on economic conditions and investor sentiment. In periods of strong growth and low uncertainty, like the 1990s tech boom, investors become less risk averse and are willing to accept lower premiums. However, recessions make investors more fearful, increasing risk aversion and driving up the required compensation for risk. Beyond macro factors, periods of investor greed and fear can push premiums away from fair levels, creating opportunities for contrarian investors.
Challenges in estimating appropriate long-term risk premiums
While risk premiums seem straightforward in theory, estimating appropriate levels is difficult in practice. Statistical approaches like historical averaging have flaws, while survey and model-based techniques have their own weaknesses. Premiums that seem reasonable in one period may appear too high or low in retrospect. Ultimately, computing fair risk premium estimates requires judgment based on data analysis, economic theory, and experience. Firms use techniques like relative valuation to sidestep the need to precisely quantify premiums.
In investing, there is no reward without risk. Risk averse investors naturally demand a premium – an extra return above the risk-free rate – as compensation when making risky investments. While challenging to estimate precisely, risk premiums are crucial for asset valuation, portfolio construction, and determining the attractiveness of risky projects.