Investor Corner/Start here/Foundations
1.1.9 Risk Premium
Risk premium is the extra return investors demand for accepting risk above the risk-free rate. The equity risk premium, in particular, is the single most important number behind long-term wealth creation.
The reward for uncertainty
Nobody would choose a riskier investment over a risk-free one unless it offered something extra in return. That extra expected return is the risk premium. It's not a guarantee, and in any given year it can easily be negative, but over long periods, investors who accepted equity risk have historically been compensated for it with returns well above the risk-free rate.
Why equity's premium matters most
Of all the risk premiums that exist, the equity risk premium does the most work in long-term financial planning. It's the gap between what equities have returned over long periods and what a risk-free instrument returned over the same period. That gap, compounded over twenty or thirty years, is the difference between a retirement corpus that comfortably meets its goal and one that falls well short.
The trade-off nobody can avoid
There is no way to earn a meaningfully higher expected return than the risk-free rate without accepting some risk premium's worth of uncertainty along the way. Understanding this trade-off is what makes it possible to hold equity through a bad year without panicking: the premium was never free, and the occasional bad year is the price paid for the good decades.
How PriLytics helps. PriLytics shows your portfolio's return against a benchmark over any period you choose, making it easy to see whether the risk you're taking is actually being rewarded over time. See performance vs benchmark.