What is Risk Premium?
Risk premium is the excess return that an investment provides over a risk-free rate to compensate investors for bearing additional uncertainty. If government bonds yield 3% and stocks are expected to return 10%, the equity risk premium is 7%. This premium exists because investors are risk-averse and demand compensation for the possibility of losing money.
Risk Premiums Across Asset Classes
Historically, the equity risk premium has averaged 4-6% over government bonds in developed markets. Corporate bonds offer a credit risk premium of 1-3% over government bonds depending on credit quality. Emerging market stocks carry an additional premium of 2-4% over developed market equities. Small-cap stocks have historically earned a 1-3% premium over large-cap stocks, though this premium has diminished in recent decades.
Key Considerations
Risk premiums are not guaranteed; they represent long-term averages that may not materialize over shorter periods. During market crises, risky assets can underperform safe assets for years. The risk premium is the fundamental reason why long-term investors allocate to equities despite short-term volatility, as the additional return compounds significantly over decades.