Risk Premium - Understanding The Price Of Success
In Spanish, there is a phrase “no vale la pena” and it can be translated “it isn’t worth it." This is the classic decision that an investor is forced to make in the stock market. Is the risk worth the reward; if you are willing to risk your money on an investment, the potential return should reflect an appropriate reward. Estimating the risk premium is a simple way of analyzing this situation
Calculating Risk Premium
Risk premium is the calculation of risk reward ratios you might expect to receive minus the return of a secure investment. In order to identify a secure investment, many investors will use something like US Treasury Bonds. This way it is easy to analyze your risk premium.
Let’s look at a couple of examples. In the first example you are considering a purchase of MEW Power, a small utility company. MEW Power is a very stable company and their expected return is 10%. If you take the 10% expected return and subtract the 5% baseline of the T-Bills, your risk premium is 5%.
Here’s a second example. ABC Inc is a small Internet company. They are new but have some interesting products; their expected return on investment is 20%. If you take the 20% expected return and subtract the 5% baseline of the T-Bills, your risk premium is 15%.
Understanding the Numbers
Of these two examples, which is a better investment? That depends but now you actually have a common point that you can use for analysis. It may be that you want both companies in your stock portfolio, MEW Power for its stability and ABC Inc for its profit potential. That is the beauty of calculating risk premium; you have another tool for analyzing the benefits of different stocks and how they would fit in your portfolio.
At this point the topic could easily switch to a discussion of portfolio diversification. Once you have performed your fundamental and technical analysis you can move to buy stocks that represent different sectors; by diversifying your portfolio you are able to absorb more risk on selected investments. If you look back to the example, adding MEW Power stabilizes your account. Since you already have a number of “secure” investments you realize that you can take a chance on the potential you see in ABC Inc. These are the kind of intelligent decisions you can make when you better understand a company’s position before buying.
This simple test is certainly not all the analysis you should do and there could be other factors involved. You should always ask yourself if the risk premium for particular investment options makes it worth risking your money on a particular stock.