There are safe things you can do with your money.
Now, when it comes to finance, "safe" is a relative term. Something could happen to your money no matter where you keep it. There are better options than others, though. Keeping it in a savings account, for example, not only ensures the bank's security and insurance but also the protection of the FDIC. A U.S. Treasury bond comes with the full faith and credit of the U.S. government. A certificate of deposit from a major institution is every bit as secure as the bank's pool of assets.
The overwhelming odds are, if you put your money in an investment like this, you will get it back. You won't get much more though because, with just about any investment, your return reflects your risk. An ultra-safe product will typically have a correspondingly low rate of return. The reverse holds true as well. As a product gets more risky the return tends to rise in compensation.
The market risk premium is how an investor calculates that rate of return.
What Is the Market Risk Premium?
The market risk premium is the additional return you expect in exchange for investing in a risky asset instead of a safe one. Here, "risky" is defined as any asset not generally considered "risk-free." For example, an investor would likely consider stocks, mutual funds or a corporate bond risky asset classes, while government bonds are the most common example of a risk-free investment.
Put another way, the market risk premium is the amount you would expect as compensation for taking the risk that you'll lose all your money.
For example, say a Stock X gave a 6% rate of return while a given Treasury bond gave a 1% rate of return. Stock X would have a market risk premium of 5%. It has repaid investors 5% more than they would have gotten out of a safe investment, which compensates them for the risk of losing their money.
Calculating the Market Risk Premium
Investors calculate the market risk premium with the following formula:
- Market Risk Premium = Expected Return on a Market Portfolio - Known Return on a Risk-Free Asset
This involves four specific definitions:
- Market Portfolio - A market portfolio is any collection of investments, securities or other financial assets. For the purposes of calculating the market risk premium this could mean anything from a single stock to a mutual fund with thousands of investments, as long as the portfolio is treated as a single asset for the purposes of calculating its return.
- Expected Return - The historic performance of the market portfolio asset in question. While the investor has discretion when it comes to defining the scope of history, most use the performance of an asset over the past year to define its expected return.
- Risk-Free Asset - An asset which the investor considers safe, with a zero or near-zero chance of loss. Most investors use U.S. Treasury bonds or U.S. Treasury bills for this, as they are considered the safest assets in the world.
- Known Return - The current rate of return on the risk-free asset you have chosen for your calculation.
Readers should note the degree of flexibility that an investor has in calculating the market risk premium. This is because the market premium measures how much an asset rewards the investor relative to a safe alternative. That safe alternative is a matter of the investor's discretion. If you would likely choose a long term investment, choose the rate of return on a U.S. Treasury bond for this calculation. If you would likely choose a short term investment, use the return on a U.S. Treasury bill.
To walk through another example, say we would like to measure the market risk premium of the hypothetical mutual fund Grow Fund. We would perform the following calculation:
Market Risk Premium = Expected return on Grow Fund - Known Return on a Risk Free Asset
- Expected Return - In the past year, Grow Fund averaged an 8% return.
- Risk Free Asset - We will use the 10-year Treasury bond, the most common security issued by the government.
- Known Return - The 10 year Treasury bond had a 1.47% rate of return at time of writing.
Market Risk Premium = 8% - 1.47% = 6.53%
Investors receive a return of 6.53% above what they would have received from a safe alternative investment. This compensates them for their risk of loss.
Limitations of the Market Risk Premium
It is important to understand that the market risk premium does NOT tell an investor what rate of return they should accept in exchange for investing in a risky asset. This measure only tells you how much more the asset has repaid investors compared to if they had invested in a safe asset, and it can only tell you that based on historical data.
Investors looking to decide whether or not to buy a given asset should consider their required risk premium, sometimes called required market risk premium or the hurdle rate. This is the market risk premium you require before investing in a given asset. In other words, it is how much you need an investment to pay before it is worth the risk.
The market risk premium also does not advise you on whether to invest in an asset based on its risk of loss, because this measure does not account for volatility. To determine whether an asset has a rate of return that compensates for its risk of loss investors use the Capital Asset Pricing Model (the CAPM).
This formula includes the market risk premium as part of its analysis. We explain the concept in more detail in our related article.
It's never too late - or too early - to plan and invest for the retirement you deserve. Get more information and a free trial subscription to TheStreet's Retirement Daily to learn more about saving for and living in retirement. Got questions about money, retirement and/or investments? Email Robert.Powell@TheStreet.com.