Finance 101 – The Risk Premium
Although investing isn’t governed by natural laws like we see in the natural sciences, one of the unavoidable aspects of investing is that returns are proportionate to risk. Stocks, bonds, bitcoin and everything else in between have their unique risks and rewards, which contributes to the divergence in their returns and volatility.
A business professor once quoted that “risk means more things can happen than will happen”. The higher the chance of a negative development, the higher return investors will demand to compensate them for that risk, which is known as a “risk premium”. For example, governments and corporations both issue bonds (debt) to finance their operations, however, government bonds are viewed as safer than corporate bonds. This is because the sales revenue of corporations is less stable than the tax revenue of governments, meaning an investor in corporate bonds should demand higher returns than as they run a higher risk of not being repaid.
The chart below is a simple example of the relationship between return and risk. The curved lines represent the probability of a return, the most likely scenario occurs where the curve is widest, whilst the least likely scenarios occur when the curve is narrow. This is why it’s misguided to say “shares return 8% per year”, as a range of other outcomes have a high probability of occurring.