The historical market risk premium is the difference between what an investor expects to get from a portfolio of stocks and the risk-free rate of return. Over the last century, the historical market risk premium has varied (depending on the analyst’s approach) from 3% to 12%.
- The historical market risk premium refers to the difference between the return an investor expects to see on a portfolio of stocks and the risk-free rate of return.
- The risk-free rate of return is a theoretical number that represents the rate of return on an investment that has no risk.
- All investments carry some risk, so the risk-free rate of return is only theoretical.
- The historical market risk premium can vary by up to 2% because investors have different investment styles and different tolerance for risk.
Risk-free rate of return
The risk-free rate of return is the theoretical rate of return on a risk-free investment. The risk-free rate is the interest that an investor would expect from a risk-free investment over a specified period of time. This is a theoretical number because every investment carries some risk.
The three-month US Treasury bill is often used as a substitute for the risk-free rate of return due to the perception that there is no risk of the government defaulting on its obligations.
The risk-free rate can be determined by subtracting the current inflation rate from the Treasury bond yield that matches the investment duration proposed by the investor.
In theory, the risk-free rate of return is the minimum return an investor expects because they will not take more risks unless the potential return exceeds the risk-free rate; in reality, the risk-free rate is theoretical, since every investment has some type of risk.
Understanding the market risk premium
The market risk premium consists of three parts:
- The required risk premium, which is essentially the return on the risk-free rate that an investor must make to account for the uncertainties of investing in stocks.
- The historical market risk premium, which reveals the historical difference between the market returns over the risk-free return of investments such as US Treasuries.
- The expected market risk premium, which shows the difference in return that an investor expects to obtain by investing in the market.
Why the historical risk premium varies
The expected premium and the required premium vary among investors due to different investment styles and risk tolerance.
The historical risk premium varies by up to 2% depending on whether an analyst chooses to calculate average differences in investment performance arithmetically or geometrically. The arithmetic average is equal to or greater than the geometric average. When there is more variation between the averages, there is a greater amount of difference between the two calculations. The arithmetic average tends to increase when the period of time over which the average is calculated is shorter.
There is also a notable difference in the historical market risk premium relative to short-term risk-free rates and long-term risk-free rates.