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All investors need to balance risk with the expected return on their investments. Market risk premium is a way to measure the risk of a market or equity investment when compared to an investment with a guaranteed, or risk-free, return. The market risk premium of an investment is expressed as the difference between the expected return on the equity investment and the return on the risk-free investment.
This difference is also called the security market line (SML) slope. The SML is a graph that plots the market risk of a particular investment in relation to the return of the market at a certain time. It shows all risky securities investments. Investors can easily see where an investment falls on the graph to determine the amount of risk in relation to the expected return.
The formula for calculating this market risk is part of the capital asset pricing model (CAPM). The CAPM includes the idea that investors need to be compensated for both the time value of money and the risk of the investment. The time value is represented by the risk-free return portion of the formula. Under the CAPM model, if the risk premium does not meet or beat the investor's required return to compensate for the additional risk, the investor should pass on the investment.
To calculate the current market risk premium, investors take the current risk-free investment return — usually U.S. Treasury bonds — and compare that return to the estimated return of the risky investment. For example, suppose that the current bond return is two percent, and the estimated return of the risky market investment is eight percent. The market risk premium of the risky investment would be the difference between the two yields, or six percent. The investor can then decide if the additional six percent return is worth the added risk.
Investors also use different types of market risk benchmarks to determine risk. These include the historical market risk premium, and the expected market risk premium. The historical market risk premium compares the historical return of the stock market compared to U.S. Treasury bonds. The expected market risk premium compares the estimated future returns of the stock market compared to U.S. Treasury bond returns.
These calculations assist the investor in determining the level of risk versus a risk-free investment. They do not guarantee the rate of return or any return at all. Investors generally use risk estimates as part of an overall investment strategy.
@MrMoody - I’ve never believed that the stock market could consistently yield 10%. The Internet bubble was an anomaly.
I think when you speak of historical market returns that you have to look at a broad horizon, not just one ten year time period like the 1990s when Internet stocks went through the roof.
Looking at historical time frames, 7% does sound about right, and you would do well to put your money there than anywhere else in my opinion.
@nony - What do you think of the historical market risk premium? You often hear the caution, “past performance is no guarantee of future returns.”
So why do people look at the historical return on the stock market? Everywhere I turn, I am told that the average expected rate of return on the stock market is at least 7% - and maybe as high as 10%, and that’s why I should steer clear of CDs and other conservative investments.
If that is so, how do you explain bubbles and the fact that many people had their 401k portfolios slashed in half as a result of stock market downturns?
I came across the Sharpe ratio when I started trading. Without getting bogged down in the esoteric meaning of the formula, it’s basically a measure of market risk premium as described in the article.
It measures the return of the investment and compares it against a benchmark, risk free investment, whether it’s bonds or CDs or whatever.
You don’t really need to know all these formulas however, in my opinion. You just need to understand the basic principle that the greater the potential reward, the greater the risk.
Some investors love the potential reward but they simply can’t stomach the notion of risk. These investors lose sleep at night if their commodity drops a few percentage points in a day. They should stay with the conservative investments in my opinion.
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