What is the risk premium for investing in stocks
Movchan's Group
Dec 31, 2023We explain what equity risk premium is, how to calculate it, and what factors influence it. We also provide practical advice on risk management in the stock market.
What is Risk Premium and What Does it Depend On
Investing in stocks can potentially yield higher returns compared to investments in less risky assets, such as bonds. For taking on higher risks and potential losses, investors expect compensation from the market. The potential profit that investors receive above the so-called risk-free rate is called the equity risk premium or market risk premium (ERP).
Government securities are considered conditionally risk-free. For example, in the USA, risk-free assets are government treasury bonds (treasuries), and in Russia, they are federal loan bonds (OFZ). However, for a global investor, OFZs would not be considered risk-free as they contain a country risk premium.
It is important to understand that while government bonds are a benchmark, absolutely risk-free instruments do not exist. Besides the unlikely but possible default, conditionally risk-free assets can also be affected by factors such as inflation. High inflation in a country can devalue the real return on bonds. Additionally, there is the risk of interest rate changes: if they rise, the market price of bonds will decrease.
Risk Management When Investing in Stocks
In investment analysis, risk is defined as the probability that the actual return on an asset will differ from the expected return. It is usually divided into two components: systematic and unsystematic risks. Understanding these is important when assessing and managing risk for different types of stocks.
Systematic Risk
Also known as market risk, it affects the entire market or a significant part of it. Its sources can include recessions, inflation, interest rate fluctuations, political instability, natural disasters, etc. Investing in different countries can help mitigate the impact of such negative events related to a specific country on the portfolio. However, it is impossible to completely eliminate systematic risk, as it is considered unavoidable.
Systematic risk is measured using the beta coefficient (β), which is also used in many methods for assessing risk premium. The beta coefficient is a measure of an asset's volatility risk compared to the market. It is calculated as the covariance of the stock's return with the market return, divided by the variance of the market return. However, it is not necessary to calculate it yourself — the unique beta coefficient for a specific stock can easily be found on all stock exchanges.
Market volatility is traditionally assumed to be equal to one, so the interpretation of the relationship between beta and expected sensitivity to market changes for a specific asset is as follows:
- β = 0 — no market sensitivity,
- β < 1 — low market sensitivity,
- β = 1 — corresponds to the market (neutral risk),
- β > 1 — high market sensitivity,
- β < 0 — negative market sensitivity.
It is impossible to eliminate this risk, but it can be effectively managed through hedging strategies. It is also worth considering assets with low volatility (β) or those less susceptible to macroeconomic risks, such as those from defensive sectors.
Unsystematic Risk
Unsystematic risk is simpler: it is associated with a specific company or industry, in other words, it is local in nature. Sources of unsystematic risk can include management problems within a company, decreased demand for certain product groups, and the emergence of a new competitor that could reduce the company's market share.
Unsystematic risk can be reduced or eliminated through diversification, as it does not affect the entire market as a whole. The more assets in a portfolio, the fewer risks associated with individual companies or industries.
How to Calculate Risk Premium
So, the equity risk premium is the difference between the expected return on the stock market and the risk-free rate of return. In other words, the risk premium reflects the forecast of how much long-term investments in stocks can outperform the returns of risk-free debt instruments. Logically, the risk premium and expected return have a direct correlation: the higher the risk, the greater the expected premium, and vice versa. This is important because, in some cases, buying even a potentially high-yield asset may be unjustified due to excessive risks.
The sequence for calculating the risk premium is as follows:
- Forecast the potential return on stocks.
- Look at the expected return on risk-free bonds.
- Subtract the difference to obtain the risk premium amount.
The main difficulty lies in the first step.
Approaches to Determining Expected Return
Forecasting future price changes of instruments is always an estimate and subjective, and any value is theoretical. Not all risks can be accurately measured and adequately reflect market conditions over a certain period. Factors such as volatility risk, geopolitical conditions, or macroeconomic environment can influence the assessment. Additionally, investors' risk perceptions may vary, complicating the creation of a single standard model for calculations.
Historical Return
The simplest way to estimate the expected return on stocks is to use the average annual historical return of the asset. In this case, it is assumed that retrospective indicators serve as a guide for future returns. The formula for calculation is as follows:
where:
Ra — expected return; R1, R2, …, Rn — historical return for each year; n — number of years.
The analysis period can vary depending on the investor's preferences. For the most representative results, it is recommended to use longer terms, such as 5 or 10 years. It is also advisable to operate with adjusted indicators, excluding one-time or atypical periods with abnormally high or low deviations from the average. This will help obtain results as close to reality as possible and avoid distortions caused by extreme market events, such as the COVID-19 pandemic or the 2008 financial crisis.
This approach is easy to use but has several limitations. The main one is that past returns do not guarantee comparable results in the future. If stocks have declined, it does not necessarily mean that their future returns will lag. Additionally, the method does not take into account the current market environment and possible events such as recessions or market bubbles.
Therefore, for a more accurate assessment of expected stock returns, other methods are used, such as the Capital Asset Pricing Model (CAPM) or the Gordon Growth Model (Dividend Discount Model).
Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) is a fundamental and one of the most popular models that helps investors assess the expected return on assets considering their systematic risk (β) relative to the overall market. CAPM is an important tool in modern financial theory, especially in the context of portfolio investing and capital cost assessment.
It is recorded as follows:
where:
Ra — expected return; Rf — risk-free asset return;
Benchmarks are usually used to assess expected market returns. For calculating the risk premium in the US market, the S&P 500 and NASDAQ indices are best suited. For emerging markets, the MSCI Emerging Markets Index is relevant. For assessing the risk premium of a regionally diversified portfolio, the MSCI World Index is suitable.
Approaches to assessment may vary: some investors prefer to use retrospective return data, while others rely on consensus forecast estimates from analytical agencies and investment banks.
Including Country Risk Premium in CAPM
Despite its prevalence, CAPM has several drawbacks. For example, it is based on assumptions and does not account for extreme distortions, for which it is criticized by financial specialists. One popular modification of CAPM involves adjusting for country risk (CRP), for which there are three approaches:
Every company outside the US is equally subject to country risk. In this case, the classic model is transformed as follows:
A company's exposure to country risk is similar to its other market risks. In this case, the traditional CAPM needs to be expanded as follows:
Country risk is a separate factor. In this approach, CRP is multiplied by a variable usually denoted as lambda (λ). However, we will not delve into this modification.
The country risk premium (CRP) is based on the fact that geopolitical and economic risks have an uneven impact on different countries. These include, for example, the likelihood of war. BlackRock tracks major geopolitical risks in real-time. Economic risks are also considered, such as recessions, defaults, the ability to service national debt, currency fluctuations, etc. The risk premium in individual emerging markets is generally higher than for developed countries.
There is no need to calculate country risk, as current values are published by one of the most renowned corporate valuation experts, Aswath Damodaran. His data is considered among the most accurate and widely used in the professional finance community.
Fama-French Three-Factor Model
Eugene Fama and Kenneth French are prominent economists known for their work in the field of finance. Their research has significantly influenced the understanding of how various factors affect asset returns and how investors can use this knowledge to optimize their portfolios. They also developed the Fama-French Three-Factor Model, which extends the traditional CAPM by adding two additional factors — size and value.
These additional factors account for the tendency of smaller companies to outperform larger ones, and they allow for the assessment of risk for different types of stocks, such as growth and value. Here's how they can be defined:
- Value stocks are shares of companies trading below their perceived fair value. Such companies have usually reached a stable level of development and have a sustainable business.
- Growth stocks are shares of companies with high revenue and profit growth rates that exceed market averages.
Fama and French's research shows that the returns of small-cap companies in the US have historically outpaced large-cap stocks by 285 basis points per year from 1926 to 2012. However, in recent years, small-cap stocks have struggled to keep up with large-cap stocks. In 2024, the gap widened due to the rapid growth of large tech companies, particularly the "Magnificent Seven": Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms, and Tesla. This rally was driven by excitement around artificial intelligence.
The formula for the Fama-French Three-Factor Model is as follows:
where:
SMB (Small Minus Big) — size factor. Historically, small-cap companies have shown higher market returns compared to large ones, and SMB measures this difference;
HML (High Minus Low) — value factor. It measures the difference in returns between stocks with high and low book-to-market values, i.e., the ratio between a company's book and market value. Stocks with high book-to-market values (representing companies considered undervalued) typically demonstrate higher returns compared to stocks with low values.
Information about the model's variables — returns and factor values — can be found here.
Gordon Growth Models
The Gordon Growth Model, also known as the Dividend Discount Model (DDM), was proposed in the 1960s by American economist Myron J. Gordon.
The formula is quite simple:
where:
D — expected dividend per share in the next period, usually a year; P — current price per share; g — dividend growth rate, which can be estimated based on historical data or forecast values.
Another option is to use earnings growth instead of dividends; then the formula will mirror the P/E multiplier:
where:
E — earnings per share for the last twelve months (EPS).
The theory has become the foundation for many methods of valuing businesses and stocks. It is based on the assumption that the current stock price equals the present value of all future dividends it will yield. This model is especially useful for calculating the risk premium for dividend aristocrats — companies that have increased their dividend size annually for at least 25 years. This list includes, for example, Coca-Cola, Exxon Mobil, and AbbVie.
The main limitation of both models is their high sensitivity to parameter changes. Even a small deviation can significantly affect the assessment. Additionally, they assume that the current stock price is never fair, which is considered a significant drawback given the stock market's tendency toward volatility.
Conclusion
The risk premium reflects the additional return that investors expect to receive for taking on the uncertainty and potential losses associated with specific investments.
Calculating the risk premium allows investors not only to assess the attractiveness of stocks but also to make more informed decisions when forming portfolios.
