Stock Market Risk Premium
Risk and returns go hand in hand when speaking about stock investing. In order to achieve better results with your stocks you should harmonize the level of risk with the rewards you expect to get from the particular stock.
What is certain in stock investing is the existence of risk. On the other hand, rewards are almost ever preceded by the word "potential".
Nevertheless, for every stock investor it is important to evaluate the potential returns s/he will gain from the particular investment. This should be done in order for the investor to be sure that the rewards s/he will eventually get are in accordance with the risk levels s/he is comfortable with.
In order to do this, you should first identify "risk-free" returns offered in the market. A risk-free investment can be qualified as the type of investment which possession doesn't expose your money to any risk. Additionally, risk-free investment provides you with the basis for making your measurements.
For instance, you can use US Treasury Bonds for a yardstick against which to make measurements. Many investors use this type of bonds since they are guaranteed by the US government. As a result investors that use US Treasury Bonds as a benchmark should invest in stocks that give as a return more than the five percent offered by the bonds.
If there are investment returns above the five-percent level, this amount is referred to as risk premium. Therefore, if the potential return of a stock you have purchased is 10%, the risk premium is calculated by subtracting five percents from 10%, which results in 5% risk premium.
Next, you should determine whether the risk premium is enough in case the stock doesn't achieve the expected return. This depends on the type of stock you have purchased. For instance, a 5% risk premium is enough for a well-established large-cap stock, whereas for a small-cap stock, which is not so well-established, the risk premium may not be enough.
Risk premiums are a suitable yardstick for judging the worthiness of investing your money in particular stocks. However, when calculating the potential returns and their justification regarding the levels of risk you take, you should take into consideration many other factors.
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