The historical market risk premium is the difference between what an investor expects to make as a return on an equity portfolio and the risk-free rate of return. Over the last century, the historical market risk premium has averaged between 3.5% and 5.5%.
The market risk premium consists of three parts:
- The required risk premium, which is essentially the return over the risk-free rate that an investor must realize to justify the uncertainties of equities investments.
- The historical market risk premium, which reveals the historical difference between returns from the market over the risk-free return on investments such as U.S. Treasury bonds.
- The expected market risk premium, which shows the difference in return that an investor expects to make through investing in the market.
The expected premium and the required premium vary among investors because of different investing styles and risk tolerance. The historical risk premium varies as much as 2% depending on whether an analyst chooses to calculate the average differences in investment return arithmetically or geometrically. The arithmetic average is equivalent 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 time period over which the average is calculated is shorter.
There is also a noticeable difference in the historical market risk premium in relation to short-term risk-free rates and long-term risk-free rates. There is typically a higher market risk premium of about an additional 1% compared to the short-term risk-free rate.