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Posted by & filed under Economics & Markets, Security Selection & Market Timing, Wealth Management.

According to Nobel Laureate Eugene Fama,there are three major risk premiums.

1. Equity premium is the additional “wage” one can earn from taking stock market risk over not taking stock market risk.

2. Small cap premium is the additional “wage” one can earn from taking small company risk over taking large company risk.

3. Value premium is the additional “wage” one can earn from taking non-growing company risk over taking growing company risk.

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Here are the three risk premiums in the last ten years from 2004 to 2013.

Mkt-RF

SMB

HML

RF

2004

10.73

5.05

9.83

1.2

2005

3.1

-2.26

9.07

2.98

2006

10.59

0.32

14.28

4.8

2007

1.05

-8.07

-12.22

4.66

2008

-38.35

3.83

0.95

1.6

2009

28.27

8.63

-5.74

0.1

2010

17.39

13.58

-3.21

0.12

2011

0.47

-6

-6.91

0.04

2012

16.29

0.44

8.09

0.06

2013

35.21

7.89

0.3

0.02

Ten yrs

84.75

23.41

14.44

15.58

Now let me make a few observations to help you understand the data.

Observation 1: The last column “RF” is the risk free rate of return. It is achieved by holding short-term treasury bills. If you examine them carefully, risk free returns can be extremely low in some years, like 0.02% in 2013, but they are never negative. That’s why it is called a risk free return.

Observation 2: The total risk free return for the whole decade, from 2004 to 2013, was 15.58%. This is basically the reward for time value of money, not for taking any risk.

Observation 3: The column “Mkt-RF” denotes equity market returns over and above risk free returns. This is the additional return, or equity risk premium, investors earn from taking equity risk. Note that nine out of the last ten years the equity risk premium was positive. The total equity risk premium for the whole decade was 84.75%.

Observation 4: The column “SMB” denotes small cap stock returns above large cap stock returns, or small cap premium. As you can see, small cap outperformed large cap seven out of the last ten years. The total small cap premium for the whole decade was 23.41%.

Observation 5: The column “HML” denotes value stock returns above growth stock returns, in other words value premium. Here you can see value stocks outperformed growth stocks six out of the last ten years. The total value premium for the whole decade was 14.44%.

Observation 6: Though in the long run it pays to take equity risk, or small cap risk or value risk, in some years you may lose money doing so. That’s why they are called risk premiums.

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