Question

why does the required and expected market risk premiums differ between investors?

Answer 1

In order to know the reason why the required and expected market risk premiums differ between investors, we should first know what is market risk premium.

Market risk premium is the difference between the risk free rate of return and expected rate of return on an investment. Risk free rate here refers to the rate of return that the investors receive without any decrease in the value of their investment. For example, If a person invests money in a fixed deposit, lets say $10,000 at an interest rate of 5% for period of 1 year, then the investor will be liable to receive an interest of $500 and the initial amount invested at the maturity of the fixed deposit. So he will receive $10,500 for sure and there is no risk involved therefore this rate is risk free investment.

On the other hand if a person makes investment in shares of a company say X limited , the price of which fluctuates daily. In this manner this is not a risk free investment as the price of the stock of company X may go up or may fall. If the price of the share goes up it will be beneficial for the investor, but if the price goes down it will be a loss for investor.

Investors who make investment in various stock do it in order to receive return for the risk borne by them as well as the opportunity cost. Opportunity cost is the cost which the investor forgoes by investing the money in stocks which is equal to the return which he would have received, had he invested the money in anywhere else like a fixed deposit.

Now as we know what the market risk premium is we can know why the expected and the required rate of market risk premium is different for investors because of the investment styles and the risk tolerance by an investor. Risk tolerance is the level of risk that can be borne by an investor.

It is often said that more the risk, more is the return, therefore any investor who takes higher risk may get higher return because of the high volitility of the stocks which can either go up highly or can even come down. So the level of risk on an investment is crutial for an investor which reflects the return expected from an investment. We should also note that more risky investments can even lead to higher losses.

Investment styles of an investor are also important factor which impact the required and expected market risk premium. Investment style refers to the plan which is implemented by the investor in which he makes decision about the allocation of the funds in different individual securities. In this case if an investor uses all the funds he has in single stock, there are changes that he can earn more return if the prices go up or may lose more if the value of stock decreses.

On the other hand if the investor makes investment in various individual stocks instead of a single stock, the risk of one security can be distributed with the others. For example if an investor loses money due to fall in price of one investment, it can be balanced by the return he receives from the security whose price increases. In this way the required and expected market risk premiums differ between investors because of variety of investments done by them.