Identifying the market risk premium is identifying how much risk you are taking in relation to your expected return. It is a cornerstone of various investment and economic theories and requires a little pause to get your head around! Understanding it will transform your approach to equity investing and capital preservation. Many retail investors focus on the ‘story’ at the expense of the fundamentals. Remember you are trading with and/or against portfolio managers who focus on fundamentals.
Market risk premium definition
The moving parts
Why it is important
In economic terms it is the difference between the expected return from a stock portfolio of equities and the risk-free rate. The risk-free rate, is the rate you get from the safest investment. That means US 10 year treasuries.
The expected return is identified by using the Capital Asset Pricing Model (CAPM). At its core, the expected rate of return demands that you get compensated for the higher level of equity risk you are taking.
Understanding market premium means linking several different concepts, and having an understanding of the role of different assets. Let us start with why the US 10y treasuries are the safest investment?
The US economy is the largest in the world, backed by a stable political system and independent judiciary. This means business thrives there. As a result when systematic risk appears, investors flock to its safest asset for portfolio protection.
As the US economy is so strong, the tax receipts the US government receives are huge. In turn this means the likelihood of the US government defaulting on its treasuries is incredibly small.
This makes US 10 year treasuries the safest investment out there.
Working out the expected rate of return from a portfolio of stocks is slightly more complicated. The biggest risk to the market, one which cannot be diversified away, is systematic risk.
When systematic risk appears, it affects everyone.
An example of systematic risk is the Coronavirus-19, which forced a virtual complete worldwide economic shutdown. As a result, worldwide stock markets dropped significantly, with some stocks in the tourism and airline space losing as much as 50% of their value (British Airways (Ticker: IAG) was down -70%).
With this risk in mind, anyone investing in equities should expect a higher rate of return from equities than they would from US 10 year treasuries.
Having understood those two components, you are now able to calculate the market risk premium using the CAPM. Explaining this calculation in detail is for another article and another day. Interestingly, the CAPM includes risks you may not have considered.
Time-value is such a risk. Time value of money is a concept whereby money earned now is worth more than earning the same amount in the future. This is due to your ability to gain interest on it immediately, which benefits compounding.
There is no one theory or concept which everyone should know. Clearly everyone is applying the same basic one: buy low, sell high! Being aware of systematic risk which cannot be diversified away means you will know you cannot mitigate downside risk fully.
Yet understanding that you should ask for an equity premium, i.e. a higher return from riskier (equity) investments, means you can at least mitigate the downside when a sell off invariably takes hold!
The stock market can stay irrational longer than you can stay solvent.
No financial model or preparedness can mitigate every risk. You will do well to remember that. Despite this warning, it is important to be aware of what others attach importance to. This can involve Reddit day trading stock manipulation or high risk hedge fund managers’ strategies. At least you are able to understand what is moving markets.