Risk Premium Explained
Why do stocks provide higher returns than deposits? Understanding the concept of risk premium and its implications for your portfolio.
Note: This article discusses Indonesian financial products and markets. The principles apply globally, though specific products, regulations, and tax treatments vary by country.
Risk Premium Explained
Why do stocks provide higher returns than deposits? Why do corporate bonds pay higher interest than SBN (Surat Berharga Negara — Government Securities)? The answer lies in one fundamental concept: risk premium.
Understanding this concept will change how you view investing. Also understand stock market risks and asset allocation to manage risk effectively. how you view investing.
Basic Concept
Risk-Free Return
The starting point for all investments is the risk-free rate — the return you can get without taking any risk.
In Indonesia, the closest benchmark is SBN (Surat Berharga Negara — Government Securities) or the BI rate. As of early 2025-2026, this is around 5-6% per year.*
Why is this called “risk-free”? Because it’s guaranteed by the government. As long as the Republic of Indonesia exists, SBN will be paid.
Risk Premium = Compensation for Additional Risk
If you can get 6% per year risk-free from SBN, why would you invest in stocks that could drop 30% in a year?
Because stocks offer additional returns above the risk-free rate — this is the risk premium.
The simple formula:
Expected Return = Risk-Free Rate + Risk Premium
Risk Premium for Various Asset Classes
| Asset Class | Historical Return (Nominal) | Risk Premium Above SBN | Risk |
|---|---|---|---|
| Deposits | 3-4% | Negative (below SBN) | Very low |
| SBN | 5-7% | 0% (benchmark) | Very low |
| Corporate bonds | 7-10% | 2-4% | Low-medium |
| Stocks (IHSG)† | 10-14% | 5-8% | Medium-high |
| Small cap stocks | Varies | 7-10% (theory) | High |
Equity Risk Premium (ERP)
Equity risk premium is the most important concept. It shows how much additional return investors get from investing in stocks compared to risk-free instruments.
In Indonesia, the historical ERP is around 5-8% per year.‡ This means that over the long term, stock investors are expected to get 5-8% more per year compared to SBN investors.
But this is only a long-term average. In any given year, stocks could return -30% or +50%.
Why Does Risk Premium Exist?
1. Compensation for Uncertainty
Humans naturally avoid risk (risk averse). To make people willing to accept risk, there must be additional compensation.
2. Possibility of Loss
Stocks can go down. Corporate bonds can default. The risk of losing money is real. Risk premium compensates for this possibility.
3. Emotional Volatility
Even if you know stocks will go up in 20 years, watching your portfolio drop 30% is very unpleasant. Risk premium also compensates for this psychological burden.
Different Types of Risk Premiums
Beyond the basic equity risk premium, academic research has identified several other risk factors that historically provided additional returns:
1. Size Premium (Small Cap Premium)
Historically, smaller companies have provided higher returns than large companies, adjusted for risk. This is the small cap premium.
Why might it exist:
- Smaller companies are less researched and less liquid
- Higher business risk and bankruptcy probability
- Less institutional investor participation
In practice: The size premium has been inconsistent in recent decades, especially in developed markets. In Indonesia, small caps can be extremely illiquid and risky.
2. Value Premium
Companies trading at low valuations (low price-to-book or price-to-earnings ratios) have historically outperformed “growth” companies with high valuations.
Why might it exist:
- Value stocks are often out of favor, creating opportunity
- Behavioral biases cause investors to overpay for exciting growth stories
- Mean reversion tendency in valuations
In practice: The value premium has been challenged in the 2010s-2020s as technology growth stocks dominated. The premium exists over very long periods but can underperform for a decade or more.
3. Quality Premium
Companies with strong balance sheets, high profitability, and stable earnings tend to provide better risk-adjusted returns.
Why might it exist:
- Quality provides downside protection during crises
- Sustainable competitive advantages
- Less bankruptcy risk
In practice: Quality stocks often outperform during bear markets but may lag during speculative bubbles.
4. Emerging Markets Premium
Developing countries like Indonesia theoretically offer higher returns to compensate for:
- Political instability risk
- Currency volatility
- Less developed legal systems
- Lower liquidity
Reality check: The emerging markets premium has been inconsistent. Many emerging markets have underperformed developed markets over multi-decade periods despite higher risk.
Important Note on Factor Premiums
These premiums are not guaranteed and can disappear for extended periods. Many investors have lost money trying to capture specific factor premiums. For most passive investors, simply capturing the broad equity risk premium through diversified index funds is sufficient.
Historical Examples: When Risk Premium Worked and Failed
Success Story: IDX Composite 2009-2017
- 2009: IDX Composite at approximately 2,500
- 2017: IDX Composite at approximately 6,000
- Period return: ~140% (approximately 11-12% annually)
- SBN return same period: approximately 6-7% annually
- Risk premium captured: approximately 5% per year
Investors who stayed invested through volatility captured the premium.
Failure Story: IDX Composite 2011-2015
- 2011: IDX Composite peaked near 4,300
- 2015: IDX Composite around 4,600
- Period return: approximately 7% over 4 years (~1.7% annually)
- SBN return same period: 6-8% annually
- Negative risk premium: stocks underperformed bonds
This period taught that risk premium is not guaranteed in the short to medium term.
Global Example: US 2000-2009 (Lost Decade)
- S&P 500 in 2000: approximately 1,500
- S&P 500 in 2009: approximately 1,100
- Nominal return: negative over a full decade
- Meanwhile US Treasury bonds provided positive returns
Investors who panicked and sold locked in losses. Those who stayed (or bought more) eventually captured massive gains in the 2010s.
Behavioral Barriers to Capturing Risk Premium
The risk premium exists largely because of human psychology. If capturing it were easy and painless, everyone would do it — and the premium would disappear.
Loss Aversion
Studies show people feel the pain of losses approximately 2-2.5x more intensely than the pleasure of equivalent gains. This means:
- A 10% portfolio drop feels worse than a 10% gain feels good
- Investors panic-sell during downturns
- Many miss recoveries by staying in cash
The premium compensates for this pain.
Recency Bias
After a crash, investors become convinced “this time is different” and stocks will never recover. After a boom, they become convinced returns will continue forever.
Examples:
- Post-2008: “Stocks are dead, buy gold”
- 2017-2021: “Stocks only go up, leverage everything”
Both were wrong. The premium exists because people make these mistakes.
Herd Behavior
When everyone is panicking, it’s psychologically difficult to buy stocks even when valuations are attractive. When everyone is euphoric, it’s hard to maintain discipline and not chase performance.
Professional investors struggle with this too — their clients withdraw money during downturns, forcing sales at the worst time.
Impatience
The risk premium requires patience. Many investors:
- Give up after 2-3 years of underperformance
- Chase last year’s winners
- Constantly switch strategies
The premium rewards those who stay the course through full market cycles.
Practical Implications for Investors
1. No High Returns Without Risk
If someone offers you 20% per year returns “without risk,” it’s definitely a scam. The risk-free rate in Indonesia is around 5-6%. Anything above that definitely carries risk — which may not be explained to you.
2. Risks That Aren’t Compensated
Not all risks receive a premium. Risks that can be eliminated through diversification don’t receive compensation. This is called unsystematic or specific risk.
Example: Buying just one stock is very risky. But the additional risk from concentration in one stock isn’t compensated by the market. You can eliminate that risk through diversification — buying many stocks through an index mutual fund.
3. Risk Premium Can Change
Risk premium isn’t constant. Sometimes the market pays a large premium for risk (when investors are scared), sometimes small (when investors are euphoric).
You can’t predict or control this. What you can control: keep investing consistently.
4. Time Is Your Friend
Stock risk premium is often negative in the short term (meaning stocks underperform deposits). But the longer the investment period, the greater the chance you’ll capture a positive risk premium.
| Investment Period | Probability Stocks Beat SBN§ |
|---|---|
| 1 year | ~60% |
| 5 years | ~75% |
| 10 years | ~85% |
| 20 years | ~95% |
The figures above are estimates based on global market historical data (primarily the US market). But the message is clear: the longer you invest, the smaller the chance you’ll lose money.
Risk Premium and Asset Allocation
Understanding risk premium helps you determine the right asset allocation:
- If investment horizon is long (> 10 years): You have time to capture stock risk premium → larger allocation to stocks
- If horizon is short (< 3 years): Risk premium may not have time to materialize → larger allocation to bonds/money market
- If risk tolerance is low: Allocate less to stocks, even with a long horizon
Practical Application: Portfolio Implementation
Understanding risk premium theory is one thing; implementing it successfully is another.
Building a Risk Premium Capture Strategy
Step 1: Determine your time horizon
- < 5 years: Limited ability to capture equity risk premium reliably
- 5-10 years: Moderate probability of premium capture
-
10 years: High probability of positive premium
Step 2: Assess your risk capacity
- Can you afford to see your portfolio drop 30-40% temporarily?
- Do you have stable income and emergency fund?
- Will you need to sell during a downturn?
Step 3: Choose implementation
- Simple: Single broad index fund (IDX30, LQ45, or IHSG fund)
- Moderate: Mix of Indonesian + global index funds
- Complex: Factor-tilted funds (value, small cap) — generally not recommended for beginners
Step 4: Commit to the process
- Set up automatic regular investing (rupiah-cost averaging)
- Ignore short-term noise
- Rebalance annually if you have multiple asset classes
- Never sell in panic
Measuring Whether You Captured the Premium
After 10+ years of investing, you can evaluate:
Your realized return vs benchmark:
- Compare your portfolio return to the risk-free rate over your investment period
- Did you capture a positive risk premium?
- If not, what went wrong? (Timing errors, high fees, panic selling?)
Most investors fail to capture the full risk premium not because it doesn’t exist, but because behavioral mistakes erode returns.
When Risk Premium Isn’t Enough
Risk premium compensates for systematic, undiversifiable risk only. It doesn’t compensate for:
- Individual stock risk (can be diversified away)
- Active management mistakes
- Excessive fees (eating into returns)
- Fraud or scams
- Unnecessary market timing
Common Mistakes
”Past returns guarantee future returns”
No. Risk premium is an expectation, not a guarantee. Stocks can underperform for years.
”High risk definitely means high returns”
No. High risk means possibility of high returns. It could also mean big losses. Crypto is very risky, but there’s no guarantee of high returns.
”I can eliminate risk but still get the premium”
You can’t. Risk premium exists because risk exists. Eliminate risk = eliminate premium.
Summary
Risk premium is the most fundamental concept in investing:
- Additional return you get for accepting risk
- The higher the risk, the higher the expected premium (but not guaranteed)
- Diversification eliminates risks that aren’t compensated
- Time is the best way to capture risk premium
- No high returns without risk — if someone says otherwise, run
Passive investing works because it efficiently utilizes risk premium: broad diversification, low costs, and long time horizons.
Sources & References:
* BI Rate (BI 7-Day Reverse Repo Rate) can be accessed at Bank Indonesia website. Retail SBN data from Ministry of Finance.
† Historical IHSG returns include dividends. Data from IDX — Market Data and various Indonesian capital market research publications. Actual returns vary by period and are not a guarantee of future performance.
‡ Indonesia Equity Risk Premium (ERP) estimates based on academic research and historical market data. ERP varies by period and calculation methodology.
§ Probabilities based on global stock market studies, primarily US (S&P 500 vs Treasury bonds), as published in academic research on long-term investing. Data for Indonesia may differ due to different market characteristics.
Further reading:
- Damodaran, A. “Equity Risk Premiums: Determinants, Estimation and Implications” (updated annually at Stern NYU)
- Historical IHSG data: IDX — Market Summary
Disclaimer: This article is for educational purposes only, not investment advice. Historical returns are not a guarantee of future performance.