Risk Premium: An Extensive Guide to Equity Risk Premium
Working with the stock market can be a risky business.
When you think of the stock market, you may instantly cast your mind to Hollywood films such as the Wolf of Wall Street or The Big Short. But there’s a reason that so many films have been made about the stock market - it’s high risk, high reward.
There are always two options when you’re dealing with stock:
Do you go down the low-risk avenue? Where your money will be safe but you may not make much money? Or do you go for a high-risk option where your equity is at risk of collapsing?
This is where equity risk premiums come into play. But what exactly is the equity risk premium? We’ll take a closer look at this and more.
Here’s What We’ll Cover:
How Do Equity Risk Premiums Work?
How Do You Calculate Equity Risk Premiums?
What Is Equity Risk Premium?
Equity risk premium is a term that refers to an excess return that investing capital in the stock market provides over a risk-free rate.
Essentially, it means that investors who take on a higher level of risk when investing equity will get a premium level of compensation. This is in comparison to those who invest in risk-free options.
The size of the premium returns will vary depending on the level of risk your portfolio has. It will also change over time as the stock market risk fluctuates.
Over the long term, the market will tend to give a much higher compensation to investors who take on the greater risk of investing in stocks.
How Do Equity Risk Premiums Work?
It’s common knowledge that the stock market is a high-risk and highly volatile venture. There are many risks when investing capital in stock, but the rewards can be huge.
This is because investors who put money into the stock market will always be compensated with much higher premiums. So whatever return you earn above a risk-free investment is called an equity risk premium.
The whole idea is based on a risk-reward tradeoff. There is no one-fits-all rule with how much the compensation will be as there is no way to tell how well the equity market may perform.
Therefore, any equity risk premium is an estimation based on a backwards-looking metric. It will observe the stock market performance over a defined period of time. It will then use that historical data to estimate the potential for future returns.
How Do You Calculate Equity Risk Premiums?
When calculating an equity risk premium you tend to start with the capital asset pricing model or CAPM. This is usually written as:
Ra = Rf + βa (Rm - Rf)
- Ra = expected return on investment in a or an equity investment
- Rf = risk-free rate of return
- βa = beta of a
- Rm = expected return of the market
That means this equation can be simply reworked to create an equation for equity risk premium:
Equity Risk Premium = Ra - Rf = βa (Rm - Rf)
However, there is a thought among economists that this isn’t a generalisable concept. In fact, several stock exchanges have gone bust over the years so a focus on historical data may distort the picture.
Still, the majority of economists will agree that the concept of an equity risk premium is valid.
Key Takeaways
While equity risk premiums are an interesting look into the world of the stock market, they are not a sure-fire way to approach your investment decisions.
As equity risk premiums require the use of historical data and returns, they cannot be considered an exact science. They aren’t completely accurate so a lot more data and research would have to be put into effect before risking a large amount of capital.
It’s important to note that when investing in the stock market, there are very few “safe bets”. Any investment is a risky investment so be sure to only invest what you can afford to lose over a certain time period.
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