Risk premium

The risk premium is the difference between the highest risk-free return available (generally that from government bonds) and the rate of return investors expect from another asset over the same period.

Investors demand high returns for higher risks so they will therefore expect to make more out of holding volatile equities than more stable bonds, for example. If government bonds are returning 3% after inflation and the real return on equities is 8%, investors in equities are earning a 5% equity risk premium.

During a bull market investors begin to feel that equities are less risky than they have been in the past. The risk premium and hence the yield that they demanded from equities shrinks as a result, and this in turn is one explanation for the rise in share prices. (In theory, if bonds return 3% and equities 8% but the risk premium falls to 3% from 5%, equity prices will rise until equities yield only 6%.)

However, the fall in risk premium eventually ends as new risk factors like deflation, corporate mismanagement, terrorism, and political instability increasingly concern investors and push prices down.

Merryn

Claim 12 issues of MoneyWeek (plus much more) for just £12!

Let MoneyWeek show you how to profit, whatever the outcome of the upcoming general election.

Start your no-obligation trial today and get up to speed on:

  • The latest shifts in the economy…
  • The ongoing Brexit negotiations…
  • The new tax rules…
  • Trump’s protectionist policies…

Plus lots more.

We’ll show you what it all means for your money.

Plus, the moment you begin your trial, we’ll rush you over THREE free investment reports:

‘How to escape the most hated tax in Britain’: Inheritance tax hits many unsuspecting families. Our report tells how to pass on up to £2m of your money to your family without the taxman getting a look in.

‘How to profit from a Trump presidency’: The election of Donald Trump was a watershed moment for the US economy. This report details the sectors our analysts think will boom from Trump’s premiership, and gives specific investments you can buy to profit.

‘Best shares to watch in 2017’: Includes the transcript from our roundtable panel of investment professionals – and 12 tips they’re currently tipping. The report also analyses key assets, including property, oil and the countries whose stock markets currently offer the most value.