Risk in investments means future returns are unpredictable. There is risk in all investments, and even all transactions. In general, the greater the risk involved, the greater the expected return, and similarly, the smaller the risk involved the smaller is the expected return.
Consider the following three types of investments:
1. Treasury Bills
These are short-term government debt securities. These are the safest investment, and because of short maturity their prices are relatively stable.
2. Government Bonds
These are long-term government debt securities. Bonds’ prices are inversely proportional to the interest rates (Bond prices fall when interest rates rise and rise when interest rates fall).
3. Common Stocks (Shares in a corporation)
The investor who invests in common stocks shares in all the ups and downs of the issuing companies. And thus, it is the most risky investment among these three investments.
The following table shows the average annual rate of return on these three investments in United States over the period from 1900 to 2008.
| Investment | Average Annual Rate of Return (1900-2008) |
|---|---|
| Treasury Bills | 4.0 |
| Government bonds | 5.5 |
| Common stocks | 11.1 |
The above historical evidence confirms that the higher the risk means the higher the return, but remembers it also means higher the chances of loosing the money.
Risk Premium
The risk premium is the amount of money (or reward) the investor receive for taking on a risk.
The table above shows the average annual rate of return. So, the average risk premium, taking treasury bills as base, can be given as
| Investment | Average Risk Premium |
|---|---|
| Treasury Bills | 0 |
| Government bonds | 1.5 (5.5 − 4.0) |
| Common stocks | 7.1 (11.1 − 4.0) |