When buying a security such as a share, every investor should have an expected return in mind. After all, companies can go bust and your money could be in the bank instead, so why take the extra risk of buying shares otherwise?
There are various ways to try and calculate this 'required return' the best known method is the Capital Asset Pricing Model (CAPM). It suggests you start with a minimum risk-free return that you could get from investing in something with almost zero default risk: government IOUs, or gilts. After all, the British and American governments aren't expected to go broke (yet).
Let's say the yield on medium-term gilts is 3%. The equity risk premium is the extra return you demand from shares to make taking the risk of investing worthwhile. To try and work this out, CAPM tends to look backwards at past prices.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
The answer will vary emerging markets, for example, carry higher-risk premiums than Western markets (the US long-term figure is about 6%).
-
Smaller companies: starting to turn?The long-awaited turnaround in smaller companies is unlikely to happen just because shares are lowly-valued. However, an improving economic and interest rate backdrop could spark renewed interest in the sector. M&A activity is also providing support for the smaller companies sector
-
What are safe-haven assets and should you invest in them?Investors turn to safe-haven assets like gold and government bonds in periods of market turmoil. How do they work and should you invest in them?
