Risk Premiums: Like Hazard Pay for Your Investments

What Is a Risk Premium?

A risk premium is the investment return an asset is expected to yield in excess of the risk-free rate of return. An asset's risk premium is a form of compensation for investors. It represents payment to investors for tolerating the extra risk in a given investment over that of a risk-free asset.

For example, high-quality bonds issued by established corporations earning large profits typically come with little default risk. Therefore, these bonds pay a lower interest rate than bonds issued by less-established companies with uncertain profitability and a higher risk of default. The higher interest rates these less-established companies must pay is how investors are compensated for their higher tolerance of risk.

How a Risk Premium Works

Think of risk premium as a form of hazard pay for your investments. An employee assigned dangerous work expects to receive hazard pay in compensation for the risks they undertake. It's similar with 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. 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 construed as a true earnings reward because risky investments are inherently more profitable should they succeed. Investments in well-penetrated markets—and 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.

Premium Cost

A risk premium can be costly for borrowers, especially those with doubtful prospects. These borrowers must pay investors a higher risk premium in the form of higher interest rates. However, by taking on a greater financial burden, they could be jeopardizing their very chances for success, thus increasing the potential for 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 many debt-laden bankruptcies, investors recoup just a few cents on the dollar on their investment, despite the initial promises of a high-risk premium.

The Equity Risk Premium

The equity risk premium (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 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. 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 (CAPM):

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

The cost of equity is effectively the equity risk premium. R_f is the risk-free rate of return, and R_m-R_f is the excess return of the market, multiplied by the stock market's beta coefficient.

From 1928 to 2022, the U.S. ERP averaged 5.06%, compared with 4.6% for the 1871-1925 period and 2.9% for the earlier 1802-1870 period. From 1926 to 2002, the equity risk premium was particularly high at 8.4%, which puzzled economists. 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.

The drop in ERP since the start of 2023 can be attributed to several factors, including a rise in equity valuations and a series of interest rate hikes from the Federal Reserve boosting returns on safer fixed-income investments.

The Bottom Line

The higher the risk of losing capital, the more an investor expects to be compensated. This compensation comes in the form of a risk premium, which basically means the extra returns above what can be earned on an investment without risk.

Over the past 90-odd years, the risk premium of stocks in the U.S. has averaged about 5%. Equity markets can fluctuate a lot, though, and a higher ERP doesn’t necessarily mean you should buy, just as a lower ERP shouldn’t necessarily force you to look elsewhere.