Risk Premium

Deeper Explanation

The risk premium is the compensation that capital providers demand for tolerating uncertainty. In theory, riskier assets should offer higher expected returns than safer ones — otherwise rational investors would simply hold the safe assets. The risk premium is the mechanism by which this compensation is delivered. In practice, risk premiums are not fixed — they fluctuate dramatically with investor sentiment. During periods of fear and pessimism, risk premiums expand: investors demand more compensation for holding uncertain assets, which means they pay lower prices (since lower prices imply higher expected returns, given the same future cash flows). During periods of greed and optimism, risk premiums compress: investors accept less compensation for uncertainty, which means they pay higher prices and accept lower expected returns. This cyclical variation in risk premiums is the primary opportunity for contrarian investors. When risk premiums are abnormally wide — as they were for high-yield bonds in 2002, 2009, and during other periods of acute fear — expected returns are very high and the margin of safety is large even for conservative assumptions. When risk premiums are abnormally narrow — as they were for equities in 2000 and credit in 2007 — expected returns are low and the margin of safety is thin. Howard Marks's framework for assessing market conditions is fundamentally about risk premiums: when they are too compressed (investors are being paid too little for the risk they are assuming), reduce exposure and increase defensiveness; when they are too wide (investors are being paid too much for the risk, reflecting excessive fear), increase exposure and be aggressive. Risk premiums are observable through yield spreads in credit markets and through valuation multiples in equity markets.