How to Calculate Risk Premium

Investing in the stock market is a weighty decision for many investors, especially in this wild economic time. It is tough to know what is going on in the market from day to day, and any beginning investor is going to have a hard time deciding where and how to invest.

First, it is very important to understand that there is a direct correlation between risk and reward. The more you are willing to risk, the greater the potential reward. Although there is also a downside, the greater the risk, the greater chances are that you may lose what you have invested. This may seem absolutely obvious as you read this, but many investors struggle with this mindset. It is essential to fully adopt the understanding of how intertwined risk and reward are.

Risk premium is defined as “the difference between the rate of return on government securities and common stock”. Risk premium should be able to give you a good idea of what the market will do based on past history, if you are a believer that the market will probably repeat the things that have happened in the past.

There are several steps in how to calculate risk premium. First, you can make a list of the investments you are interested in and separate them into two categories, regular stocks and treasury securities. Next, pick a specific time period, and review the stocks performance. You want to focus on the percentage return of the equities. You then want to get the same performance information for the treasury bills.

Next, you subtract the return on the treasury bills from the return on the stocks, and this equals risk premium. This is a general risk premium and not the absolute most accurate, but it is a quick, easy way to calculate risk premium.

Risk premium is fairly easy to calculate and can help you navigate the stock market. If you need more information on how to calculate risk premium, you can check out the many websites on the internet or consult with a professional advisor.

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