This is Springwater’s Source – a topic or issue in personal finance and investing, shared visually. The Source will share one concept, once a month, in about a minute or less.

Risk Premium Image

An important concept derived from financial economics is that of a “risk premium”.

In a nutshell, this premium is what investors can expect to earn over and above the risk-free return (on safe investments like short-term government bonds) for investing in securities with uncertain returns.

For US stocks, the equity risk premium was a bit less than 5% for the 50-year period from 1965-2015, as shown on the bar on the left. Stocks returned about 9.7%, while the risk-free rate was about 4.9%.

The risk-free rate is likely be no more than 2% for some time – it is currently well below that level. If we add to that our “best guess” for the equity risk premium – 4.8% – we arrive at a projected return for US stocks of about 6.8%. This is shown on the bar on the right.

The implications of US stocks potentially earning a third less than their long-term historical average are significant.