Equity Risk Premium: No Free Lunch Principle

by | Oct 16, 2014 | News, Stock Market Comments

With all the recent volatility in the market, it’s provided a good opportunity to remind people what risk premium is all about. Owning equity (stocks) inherently means you’re taking on more risk in return for the possibility of a larger reward. This is something a lot of investors forget. Josh Brown of The Reformed Broker recently had a great post about why stock investors get paid where he wrote:

“Bond investors, the lenders in this example, only ever get principal back and their interest payments – and over long stretches of time their after-tax, after-inflation profits from this activity are nowhere near what they could be had they owned equity.

Owners (equity investors) on the other hand, have a share in the future productivity of the enterprise – a much greater potential payout over time than bond interest and the return of their original capital – but they endure greater risk in order to earn this (the No Free Lunch principle).”

I enjoy Josh’s simple style of writing. He puts it into terms that are clear and understandable. My favorite part from the quote above is the “No Free Lunch principle”. Wouldn’t it be great it investors could earn higher returns without taking on more risk? Alas, you cannot have one without the other.

In the midst of a week like we’re currently experiencing, it’s a good opportunity to remind equity investors why they get paid a risk premium over bond investors.



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