Risk premiums are something else than profits. They're much more intangible, much more "macro".
If you have three companies, two of which will produce $1M (when discounted with interest rates), and the third one has the prospects of producing $1M but will actually produce $0 due to some fatal flaw in the idea (i.e. will lose everything), but you don't know and can't know which one is the loser - how much should each stock be worth? Assume there's no debt.
It's pretty obvious that it should be less than $1M per company. That's what the risk premium is - the difference between discount rates used for a risky project vs the discount rate used for a non risk asset (i.e. interest rates).
No risk premium means everything is discounted as a "sure thing", as if it was a government bond. It's inherently anti-capitalistic because it means that the capital doesn't get to decide what's possible, what's probable, and what's likely.
Also, note that risk premiums have, a priori, nothing to do with aggregate returns. Risk premium is what you'd make if everything went well. But it often doesn't go well. In my example if all three companies traded for $666k and you bought all three you'd end up with the same amount of money at the end (once the loser is known).
I didn't/don't think that's what the phrase means.
If the expected value is $666,666 then wouldn't be the risk premium be the discount you want for the risk of getting zero, compared to an investment that definitely returns $666,666?
I also feel like I read recently about a study showing that investors are empirically (at least to some extent and at least these days) willing to pay more for more "risk", kind of like lottery players.
I'm a little foggy about why, with the low cost of diversification, investors would demand a risk premium greater than zero, at least.
> If the expected value is $666,666 then wouldn't be the risk premium be the discount you want for the risk of getting zero, compared to an investment that definitely returns $666,666?
Risk premium is something that connects future profits to the present, to create an expected value. It is in fact, typically, a yearly rate expressed in percent. Simple example: say the 10 year bond is 2%, you slap 5% risk premium on top of that and you get 7%, with which you discount future profits to the present expected value. Why 5%? Well that's why I'm calling it "intangible". It's risk, it's hard to say what risk is when often you could not have possibly anticipated all the problems. But you know that they're there. All of the recorded history of humanity confirms that trouble is always there.
> I'm a little foggy about why, with the low cost of diversification, investors would demand a risk premium greater than zero, at least.
Well that's up for everyone to decide [what risk premium do they want]. I'd personally stay on the side that assumes that failure, any level, size and scope of failure, is always possible.
Broad diversification was always possible and executed at the institutional scale. It really doesn't change all that much. All that changed is that the "small guy" can have it. In particular it does not mean that risk was somehow banished from the world by Jack Bogle's work.
In your toy example, it's a huge difference. You have a 1/3 chance of losing all your money without it, but a zero chance if you own all three.
With the stock market, it's not clear exactly what diversification gets you because nobody has the future correlation matrix, but it must be worth something. I think millions of people are implicitly assuming the whole market can't go to zero.
If you have three companies, two of which will produce $1M (when discounted with interest rates), and the third one has the prospects of producing $1M but will actually produce $0 due to some fatal flaw in the idea (i.e. will lose everything), but you don't know and can't know which one is the loser - how much should each stock be worth? Assume there's no debt.
It's pretty obvious that it should be less than $1M per company. That's what the risk premium is - the difference between discount rates used for a risky project vs the discount rate used for a non risk asset (i.e. interest rates).
No risk premium means everything is discounted as a "sure thing", as if it was a government bond. It's inherently anti-capitalistic because it means that the capital doesn't get to decide what's possible, what's probable, and what's likely.
Also, note that risk premiums have, a priori, nothing to do with aggregate returns. Risk premium is what you'd make if everything went well. But it often doesn't go well. In my example if all three companies traded for $666k and you bought all three you'd end up with the same amount of money at the end (once the loser is known).