Risk premium - Why you earn more on risky investments

Fundamental Concept

Risk premium is simply about: the extra profit you can expect when you invest in something that is riskier than a safe investment. Different investments require different compensation for risk – this depends on market volatility, the possibility that a borrower will not repay (default risk) or how quickly you can sell the asset (liquidity). For investors, it is key to choosing the right assets based on personal risk appetite and investment goals.

From Theory to Practice: What Happens When You Invest?

Investment is never just about maximizing returns – it's about balance. Certain assets such as government bonds or gold are seen as safe. The opposite is stocks, real estate, or cryptocurrencies, where higher risk is almost synonymous with high hopes for returns.

Risk premium is the tool that helps you compare these different ways of growing your money without taking on more risk than you can bear.

How risk premium works - a practical example

The idea behind risk premium is completely logical. When you invest money in something riskier, you expect better compensation than if you just kept it safe. This difference – between what you can earn from something risky versus something safe – is the risk premium.

In the USA, government Treasury bonds are classified as safe because a government default is extremely unlikely. However, if you choose to invest in something less predictable instead, you require a higher reward for this risk.

Concrete example: if a U.S. government bond offers 2% interest and a corporate loan offers 5%, the risk premium between them is 3%. The company offers more because there is a real risk of missing payments or going bankrupt.

Why investors need to understand risk premium

The most important reason is simple: it allows you to compare. You cannot just choose the option with the highest return – you must weigh in the probability that you will actually achieve that return and not lose money instead.

Professionals use risk premium in models such as the Capital Asset Pricing Model (CAPM) to calculate what an investment should ideally yield considering its level of risk.

Moreover, a good understanding of risk premiums can encourage you to diversify – spreading your investments across various assets with differing risk levels. This creates a better balance between aiming for larger gains and avoiding unnecessary exposure.

Different types of risk premiums that investors face

There are several types of risk premiums because different risks exist in different ways.

Equity risk premium is the extra return you expect when you buy stocks instead of staying in safer options like government bonds. Stocks fluctuate more than bonds, so the premium is usually larger.

Credit risk premium is the compensation for lending money to uncertain borrowers – companies or countries with shaky financial health that may not be able to repay.

Liquidity risk premium applies to assets that are difficult to sell quickly, such as certain real estate or rare collectibles. To be worthwhile, they must offer a higher expected return.

Cryptocurrencies and their own risk premium

The cryptocurrency market has developed its own unique risk premium. Since this market is relatively young and can be very volatile, investors typically expect significantly higher potential returns than from traditional stocks or bonds.

Bitcoin is considered the safest choice in crypto, while altcoins carry much higher risks. Price fluctuations, changing regulations, hacking risks, rug pulls, and shifting market narratives create additional uncertainty. All of this is reflected in the higher risk premiums that crypto investors expect – and this is entirely rational given the environment.

Calculate your own risk premium

The formula is very straightforward. You simply take the expected return on the risky option and subtract what you would earn from something safe.

Example: If you believe a stock can provide an 8% annual return and a government bond provides 3%, then the risk premium is 5%.

This is not set in stone. The size of the prize fluctuates depending on market conditions, investor sentiment, and what makes the investment special or unusual.

What changes the risk premium?

Risk premiums are in constant motion. Macroeconomic conditions or sudden market shocks can cause investors to demand more compensation – or sometimes they may be satisfied with less.

In times of higher uncertainty, risk premiums rise. When the market feels stable and everyone is secure, premiums decrease. It also matters what applies to specific investments – new assets, those that are difficult to sell quickly, or very volatile ones, typically have higher premiums.

Major news or macro events can also quickly affect risk premiums across entire sectors or countries.

Concluding reflections

Understanding risk premium is immensely valuable for anyone looking to make smarter investment decisions. By knowing what it is, how to calculate it, and what influences it, you can build a portfolio that aligns with your goals and risk tolerance.

In the end, the risk premium reminds us of a fundamental truth: if you want a chance at greater profits, you must almost always accept some extra risk. The art lies in knowing when this trade-off is justifiable for you.