Understanding risk premiums — or “risk premia” — is a tricky business, but it’s important. Essentially, a risk premium is the amount of money that an investment can be expected to return above the return on a risk-free asset.
The nature of the stock market is unpredictable, which is why people who take bigger risks potentially stand to gain bigger rewards through equity risk premium. However, the reverse is also true. Taking risks can cost you money if your investment suddenly goes south. Those who purchase conservative investments take less risk, and likely will earn less money in return. But their chances of losing a fortune also are minimized.
Investments that offer risk-free rates include savings accounts and CDs, which pay you back at a fixed rate over a defined period of time. Other, safer investments include bonds. Bonds are a bit riskier than savings accounts and CDs, but are less risky than stocks.
Investing in the stock market and cashing in on excess equity risk premiums is tempting. But there’s no guarantee of big returns, regardless of what Wall Street’s best analysts predict. Here are five essential things everyone should know about risk premiums.
1. Negative Risk Premiums Matter
Risk premiums basically reward investors for taking on risks. However, they can be costly when the risk outweighs the reward — a situation known as a negative risk premium.
A prime example of such a premium occurs when stocks — which carry more inherent risk than bonds and usually pay a higher risk premium — generate returns lower than those of the less-risky bonds.
2. Stock Market Predictions Can Help
No one can know what the stock market will do tomorrow. Still, it’s important to make educated predictions based on history and the information at hand before investing in stocks that have high risk, but also the potential for high returns.
A caveat you hear in many investment ads is “past performance is no guarantee of future results.” Keep this cautionary note in mind when deciding how to invest your money.
3. How Much You’re Willing to Lose
At some point, investors in the stock market have to ask themselves how much of a loss they can handle. Understanding your financial goals and what it will take to reach them is a step in the right direction.
Your investment allocations will look different depending on your wants, needs and expectations.
4. Interest Rates Matter
The not-so-black-and-white world of interest rates has stock market experts disagreeing on how higher rates affect the market. But the experts do agree that interest rates have a huge impact on the market, both positive and negative.
Some believe higher rates mean a stronger economy — which leads to stronger businesses and more valuable stocks. But others disagree.
For example, a study by Robert R. Johnson, president of the American College of Financial Services in Bryn Mawr, Pa., found the market does better in an expansive rather than restrictive economy. An expansive economy is one in which interest are lower, whereas a restrictive economy has higher rates.
Johnson cites the following research as proof of this: From 1966 through 2013, Standard & Poor’s 500 index returned 15.2 percent annually during expansive periods and 5.9 percent during restrictive periods. So keep an eye on rates whenever you invest.
5. It’s Best to Decrease Your Exposure As You Age
The common advice of financial advisors is that you should reduce exposure to risk as you near retirement. The idea is that shifting your funds from riskier stocks to low-risk, lower-yield bonds is a sensible move that will keep your nest egg intact.
For example, a New York Times report from earlier this year found that target-date funds offered by four major mutual fund companies — BlackRock, Capital Group, Fidelity and Vanguard — all had stock allocations of between 84 and 97 percent for people who plan to retire in 2045. By contrast, funds for people planning to retire in 2020 had stock allocations of 52 to 61 percent.
This ratio of stocks and bonds changes for people who are about to retire relatively soon. It does this as a way to help people manage risk as their cash flow decreases.