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 ranged (depending on the approach of the analyst) from 3% to 12%.
- Historical market risk premium refers to the difference between the return an investor expects to see on an equity portfolio and the risk-free rate of return.
- The risk-free rate of return is a theoretical number representing the rate of return of 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 as much as 2% because investors have different investing styles and different risk tolerance.
Risk-Free Rate of Return
The risk-free rate of return is the theoretical rate of return of an investment with no risk. The risk-free rate is the interest an investor would anticipate 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 U.S. Treasury bill is often used as a proxy for the risk-free rate of return because of 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 yield of the Treasury bond matching the investor's proposed investment duration.
In theory, the risk-free rate of return is the minimum return an investor expects because they won't take on any more risk unless the potential return surpasses the risk-free rate; in actuality, the risk-free rate is theoretical, since every investment has some sort of risk.
Understanding the Market Risk Premium
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.
Why the Historical Risk Premium Varies
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.