# Understanding Risk Premiums: Boosting Returns for Risky Investments

## What Is a Risk Premium?

A risk premium represents the extra return expected from an investment beyond the risk-free rate. It compensates investors for the additional risk they undertake, similar to hazard pay in high-risk jobs. High-risk investments, like stocks or less stable bonds, must promise higher potential returns to justify the risk of potential loss.

### Key Takeaways

*   A risk premium compensates investors for the higher risk of investments, providing returns above the risk-free rate.
*   Investors typically receive higher premiums for riskier investments, as they accept a greater chance of potential loss.
*   The equity risk premium (ERP) reflects the extra return over a risk-free rate by investing in stocks, often estimated using the CAPM model.
*   From 1928 to 2022, the U.S. ERP averaged around 5%, demonstrating expectations for additional compensation from stock investments.
*   Market conditions can cause ERPs to fluctuate, impacting the attractiveness of stock investments at different times.

![Risk Premium: The return in excess of the risk-free rate of return that an investment is expected to yield.](https://www.investopedia.com/thmb/KCFJ_b6dRB3JhNCLFNutqcGFX7s=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Riskpremium_final-df76f6b70fd144698c4bbf58203c1b85.png)

*— Investopedia / Michela Buttignol*

## Understanding Risk Premiums: Hazard Pay for Your Investments

Think of a risk premium like hazard pay for investments, compensating for the risk of loss. It's similar to risky investments. A risky investment must provide the potential for larger returns to compensate an investor for the risk of losing some or all of their capital.

This compensation comes in the form of a risk premium, which is the additional returns above what investors can earn risk-free from investments such as a U.S. [government security](https://www.investopedia.com/terms/g/governmentsecurity.asp). The premium rewards investors for the prospect of losing their money in a failing business, and it isn't actually earned unless the business succeeds.

A risk premium can be viewed as a reward, as successful, high-risk investments are often more profitable. Investments in well-penetrated markets—which tend to have predictable outcomes—are not likely to change the world. On the other hand, paradigm-shifting breakthroughs are more likely to come from novel and risky initiatives. It's these types of investments that can potentially offer superior returns, which a business owner may then use to reward investors. This one underlying incentive is why some investors seek riskier investments, knowing they can reap potentially bigger payoffs.

## The Financial Impact of Risk Premiums on Borrowers

Borrowers with uncertain prospects often face costly risk premiums, resulting in higher interest rates. By taking on more debt, they risk failure and a higher chance of default.

With this in mind, it is in the best interest of investors to consider how much risk premium they demand. Otherwise, they could find themselves fighting over debt collections in the event of a default. In bankruptcies, investors often recover only a few cents per dollar, despite promised high-risk premiums.

> **Important**
>
> While economists acknowledge an equity premium exists in the market, they are equally confused as to why it exists. This is known as the equity premium puzzle.

## Exploring the Equity Risk Premium: Calculations and Trends

The [equity risk premium](https://www.investopedia.com/terms/e/equityriskpremium.asp) (ERP) refers to the excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of buying stocks.

The size of the premium varies depending on the [level of risk](https://www.investopedia.com/terms/r/risk-profile.asp) in a particular portfolio and also changes over time as market risk fluctuates. As a rule, high-risk investments are [compensated with a higher premium](https://www.investopedia.com/the-moron-risk-premium-11711745). Most economists agree the concept of an equity risk premium is valid: over the long term, markets compensate investors more for taking on the greater risk of investing in stocks. 

The equity risk premium can be computed in several ways, but is often estimated using the [capital asset pricing model](https://www.investopedia.com/terms/c/capm.asp) (CAPM):

$\begin{aligned} &\text{CAPM(Cost of equity)} = R_f + \beta ( R_m - R_f ) \\ &\textbf{where:} \\ &R_f = \text{Risk-free rate of return} \\ &\beta = \text{Beta coefficient for the stock market} \\ &R_m - R_f = \text{Excess return expected from the market} \\ \end{aligned}$

The cost of equity is effectively the equity risk premium. Rf is the risk-free rate of return, and Rm\-Rf is the excess return of the market, multiplied by the stock market's [beta](https://www.investopedia.com/terms/b/beta.asp) coefficient.

Between 1928 and 2022, the U.S. ERP averaged 5.06%, higher than 4.6% from 1871-1925 and 2.9% from 1802-1870. From 1926 to 2002, the equity risk premium was a puzzlingly high 8.4%. From 2011 through 2022, the average market risk premium in the U.S. was 5.5%.

#### What Is the Current Equity Risk Premium?

At the beginning of May 2023, the ERP stood at 4.77%, according to Aswath Damodaran, a professor at the Stern School of Business at New York University. That is slightly less than average and a sharp drop from the 5.94% registered at the start of 2023.

Lower ERPs generally make investing in stocks less compelling, whereas higher ERPs imply higher potential rewards. The year 2022 was a volatile one for stock markets, and the ERP subsequently moved quite a bit. According to Damodaran, it started 2022 at 4.24% and began 2023 at 5.94%, perhaps implying that the market was viewed as undervalued after a sharp sell-off.

Factors like rising equity valuations and Fed interest hikes have decreased the ERP since 2023.  

### 5.6%

The average U.S. equity risk premium in 2022.  

## What Is the Risk Premium for an Investment?

The risk premium is the extra amount you're expected to get for taking on risk. It is the percentage return you get over what you’d receive if you made an investment with zero risk. So, for example, if the S&P has a risk premium of 5%, it means you should expect to get 5% more from investing in this index than from investing in, say, a guaranteed certificate of deposit.

## What Is an Example of a Risk Premium?

Let’s say you invest in a stock that is expected to deliver an annual return of 8%, including dividends. If you could get an annual return free of risk of 3% elsewhere, the risk premium for this stock would be 5%.

## How Is Risk Premium Calculated?

The risk premium can be calculated by subtracting the expected return of a risk-free investment from the expected return of an investment with risk. What you are left with is the compensation for the risk you’re taking on.

## The Bottom Line

Investors expect compensation for taking on higher risk, often in the form of a risk premium, which represents potential returns above risk-free investments. Historically, U.S. stocks have averaged a risk premium of about 5% over the last 90 years.

However, market fluctuations mean a high equity risk premium (ERP) does not automatically suggest a buying opportunity, nor does a lower ERP imply selling. Investors should assess risk versus potential reward, keeping in mind that risk premiums serve as incentives for tolerating market uncertainties.  
  

> **Article Sources**
>
> 1.  Forbes. "[You Need to Understand the 'Equity Risk Premium'](https://www.forbes.com/sites/kerrypechter/2020/04/04/erp-zirp-and-when-to-get-back-into-the-market/?sh=249fa0106e4d)."
>     
> 2.  Stern School of Business. "[Equity Risk Premiums (ERP): Determinants, Estimation, and Implications – The 2023 Edition Updated: March 23, 2023](https://deliverypdf.ssrn.com/delivery.php?ID=394013103113027026117021103122067109050063050068079069007115006009071030107023122009034102098026110059062000093116087008014069045007060077040002017104084114108048012022119127003083001010031000085005086089098100085075028012011093002121024070004020&EXT=pdf&INDEX=TRUE)," Page 103
>     
> 3.  Universidad Francisco Marroquín. "[The equity premium in 150 textbooks](https://jnf.ufm.edu/cgi/viewcontent.cgi?article=1009&context=journal)."
>     
> 4.  Wharton University of Pennsyvania. "[The Historical Market Risk Premium: The Very Long Run](https://finance.wharton.upenn.edu/~acmack/Chapter_09_app.pdf)."
>     
> 5.  J. Siegel, Jeremy, and Richard H. Thaler. "Anomalies: The Equity Premium Puzzle." _Journal of Economic Perspectives_, vol. 11, no. 1, 1997, pp 191-200.
>     
> 6.  Statista. "[Average market risk premium in the United States from 2011 to 2022](https://www.statista.com/statistics/664840/average-market-risk-premium-usa/)."
>     
> 7.  Wharton University of Pennsyvania. "[The Historical Market Risk Premium: The Very Long Run](https://finance.wharton.upenn.edu/~acmack/Chapter_09_app.pdf)."
>     
> 8.  Stern School of Business. "[Damodaran Online](https://pages.stern.nyu.edu/~adamodar/)."
>     
> 9.  Aswath Damodaran Blog. "[Data Update 3 for 2023: Inflation and Interest Rates](https://aswathdamodaran.blogspot.com/2023/01/)."