What is meant by the term "risk premium"?

The term "risk premium" refers to the additional return that an investor expects to earn from a risky investment compared to a risk-free investment, typically represented by government bonds. This excess return compensates investors for taking on additional risk. In financial theory, the risk premium can be thought of as a reward for investing in assets that have uncertain outcomes, recognizing that some investments come with higher levels of volatility and potential loss.

In practical terms, when investors compare the anticipated return on an investment—such as stocks or corporate bonds—to the return on a risk-free asset, the difference is referred to as the risk premium. This concept is central to investment decision-making and portfolio management, as it helps investors determine whether the potential returns justify the risks involved.

Understanding risk premium is crucial for evaluating investments and understanding how they fit within an overall financial strategy. The ability to differentiate between risk-free returns and those that carry risk helps investors make informed choices aligned with their risk tolerance and investment goals.