Risk Premiums Across US Asset Classes

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You allocate your portfolio 60% stocks and 40% bonds instead of 100% bonds, accepting higher volatility (18% standard deviation vs 6%) in exchange for an extra 4-5% annual return over decades. That 4-5% difference is the equity risk premium—the additional return investors demand for bearing stock market crashes, recessions, and 30-50% drawdowns. The practical antidote: understand risk premiums across asset classes (stocks vs bonds vs cash) to calibrate how much volatility you must accept to hit your wealth goals.

Risk Premium Defined: Extra Return for Extra Risk

A risk premium is the excess return an asset class delivers above a "risk-free" baseline (typically 3-month Treasury bills or 10-year Treasury bonds). Investors require this premium to compensate for uncertainty—stocks might deliver 10% annually over 30 years, but they could also drop 37% in a single year (as in 2008). Bonds might only return 5-6%, but they rarely fall more than 10% annually.

The formula is simple:

Risk Premium = Risky Asset Return - Risk-Free Asset Return

Example using historical averages (1926-2025):

  • Equity risk premium = 10.38% (S&P 500) - 5.5% (bonds) = 4.88%
  • Bond risk premium = 5.5% (bonds) - 3.5% (T-bills) = 2%

The point is: higher risk = higher expected return (but not guaranteed). Stocks sit atop the risk pyramid (highest volatility, highest premium), followed by bonds (moderate volatility, moderate premium), followed by cash (no volatility, no premium). You choose where to allocate based on your tolerance for drawdowns and your time horizon.

Why this matters: risk premiums aren't just historical data—they're the engine of long-term wealth compounding. A 4.88% annual premium over 40 years turns $100,000 into $2.94 million (stocks at 10.4%) versus $903,000 (bonds at 5.5%)—a $2 million wealth gap from accepting volatility.

Equity Risk Premium: Stocks Over Bonds (1871-2023)

The equity risk premium is the most studied and debated premium in finance. Over 152 years (1871-2023), US stocks delivered ~4.5% annualized real returns over bonds—the reward for enduring bear markets, volatility spikes, and multi-year drawdowns (Source: Finaeon).

But the premium varies dramatically by measurement period:

  • Past 91 years (1933-2023): 6.7% equity premium (post-Depression recovery era)
  • Past 23 years (2001-2023): 2.3% equity premium (includes dot-com crash, 2008 financial crisis, COVID)
  • Common academic estimate: 3-4% for US and UK markets (forward-looking, not historical)

The durable lesson: risk premiums are not constant. They compress during bull markets (when stocks get expensive relative to bonds) and expand during bear markets (when stocks get cheap). The 1990s tech boom shrunk the premium to near-zero; the 2008-2009 crash expanded it to 8%+.

Current context (December 2025): 10-year Treasury yields 4.12%, S&P 500 earnings yield ~4.5% (inverse of P/E ratio of ~22). Implied equity risk premium: 0.38%—historically low, signaling stocks are expensive relative to bonds or expected returns have fallen. This doesn't mean "sell everything," but it does mean expect lower forward returns (perhaps 7-8% nominal vs historical 10.4%).

Asset Class Hierarchy: Risk and Return Spectrum

Here's the full US asset class ladder from lowest to highest risk (with historical annualized returns, 1926-2025):

1. Treasury Bills (3-month, "cash"):

  • Return: 3-4% nominal, 0-1% real (after 3% inflation)
  • Volatility (std dev): 0-1% (virtually no price fluctuation)
  • Risk premium: 0% (this is the risk-free baseline)
  • Use case: emergency fund, short-term savings (<1 year)

2. Investment-Grade Bonds (Bloomberg US Aggregate):

  • Return: 5-6% nominal, 2-3% real
  • Volatility: 5-8% (2-4x less volatile than stocks)
  • Risk premium: 2% over T-bills
  • Use case: portfolio stability, retirees needing income, 3-10 year goals

3. Large-Cap Stocks (S&P 500):

  • Return: 10.38% nominal, 7.2% real (Source: Official Data, 1926-2025)
  • Volatility: 15-20% (3-4x more volatile than bonds)
  • Risk premium: 4-5% over bonds, 6-7% over T-bills
  • Use case: long-term growth (10+ years), retirement accumulation

4. Small-Cap Stocks (Russell 2000):

  • Return: ~12% nominal (historical premium over large-cap)
  • Volatility: 25-30% (50% more volatile than S&P 500)
  • Risk premium: ~1.5% over large-cap, ~8% over T-bills
  • Use case: aggressive growth, long time horizon (15+ years)

5. Emerging Market Stocks:

  • Return: ~12-14% nominal (with currency risk, political risk)
  • Volatility: 30-40% (2x S&P 500 volatility)
  • Risk premium: ~3-4% over S&P 500 (not guaranteed; periods of underperformance)
  • Use case: diversification, very long time horizon, high risk tolerance

The test: if you need 8% real returns to hit your retirement goal, you must accept stock-level volatility (15-20% standard deviation). Bonds at 2-3% real and cash at 0-1% real won't get you there—no amount of "safe" investing compounds to aggressive wealth targets.

Historical Evidence: 30-Year Rolling Returns

Risk premiums compress and expand over short periods (1-5 years), but over 30-year rolling periods, they're remarkably consistent. From 1926-2025, looking at every 30-year window:

Stocks (S&P 500):

  • 30-year annualized return: 10.44% average across all windows
  • Best 30-year period: 13.7% (1970-1999, tech boom)
  • Worst 30-year period: 8.5% (1929-1958, Depression + WWII recovery)
  • Never negative over 30 years

Bonds (investment-grade):

  • 30-year annualized return: ~6% average
  • Best 30-year period: ~9% (1981-2010, falling interest rates)
  • Worst 30-year period: ~3% (1950-1979, rising inflation)

Cash (T-bills):

  • 30-year annualized return: ~3-3.5% average
  • Tracks inflation closely; occasionally negative in real terms

The practical point: over 30 years, stocks beat bonds by 4-5% with near-certainty. Over 40 years, stocks have beaten bonds 100% of the time since 1926. The equity risk premium is durable—but you must endure multi-year drawdowns to collect it.

Volatility as the Price of Higher Returns

The equity risk premium exists because stocks are 3-4x more volatile than bonds. Standard deviation (a measure of return variability) for each asset class:

  • S&P 500: 18% annualized std dev → in 68% of years, returns fall between -8% and +28% (average 10% ± 18%)
  • Bonds: 6% annualized std dev → in 68% of years, returns fall between -1% and +11% (average 5% ± 6%)
  • Cash: <1% std dev → virtually flat returns year-to-year

The point is: risk premium = compensation for volatility. Stocks deliver higher returns because investors demand payment for enduring -37% years (2008), -18% years (2022), and even -43% intra-year drawdowns (March 2020). If stocks weren't volatile, the premium would vanish (everyone would own stocks, bidding prices up until returns equaled bonds).

Why this matters: you can't "hack" the system by holding stocks without accepting volatility. Tactical investors who sell during drawdowns (2008, 2020, 2022) forfeit the risk premium—they experience the downside but miss the snapback rallies. The premium only accrues to buy-and-hold investors willing to ride through -20% to -50% declines.

The durable lesson: volatility is not a bug, it's the feature you're paid to tolerate. A portfolio that never falls 20% will never deliver 10% long-term returns.

Bond Risk Premium: Why Bonds Beat Cash

Bonds deliver 2% annualized premium over T-bills (historically), compensating investors for duration risk (bond prices fall when interest rates rise) and credit risk (corporate bonds can default). The longer the maturity and the lower the credit rating, the higher the premium.

10-year Treasury vs 3-month T-bill:

  • 10-year average yield: ~5% (over past 50 years)
  • 3-month average yield: ~3.5%
  • Term premium: 1.5% (compensation for locking money up for 10 years and accepting interest rate risk)

Corporate bonds (investment-grade) vs Treasuries:

  • Corporate bond yield: ~6% (current)
  • 10-year Treasury yield: 4.12% (current)
  • Credit spread: 1.88% (compensation for default risk)

When interest rates rose from 0.5% (2020) to 5% (2023), 10-year Treasury bonds fell ~20% in price—duration risk realized. Investors who held to maturity still collected their stated yields, but those who sold took losses. The 1.5% term premium is payment for accepting this risk.

The practical antidote: bonds aren't "safe" in the short term (they fluctuate with rate changes), but they're safer than stocks (5-8% volatility vs 18%). The 2% premium over cash makes bonds appropriate for 3-10 year goals where you need some growth but can't tolerate stock drawdowns.

Current Risk Premiums and Asset Allocation Implications (2025)

As of December 2025, current yields and implied premiums have shifted from historical norms:

10-year Treasury: 4.12% S&P 500 earnings yield: ~4.5% (inverse of P/E ~22) Implied equity risk premium: 0.38% (4.5% - 4.12%)

This is historically low—the long-term average equity risk premium is 3-4%. Low premiums signal either (stocks are overvalued relative to bonds), (expected stock returns have fallen), or (bond yields will rise, causing bond losses and widening the premium again).

Practical implications:

  1. Rebalance toward bonds if equity premium <2%: When stocks offer minimal premium over bonds, the risk-return tradeoff favors bonds (you're not getting paid enough for volatility).

  2. Increase stock allocation when equity premium >5%: During market crashes (2008, 2020), equity premiums spike to 6-8%—stocks become "cheap" relative to bonds.

  3. Expect lower forward returns when premiums compress: If stocks historically returned 10.4% with a 4.5% premium, a 0.4% premium suggests expected returns around 6-7% (not 10%).

  4. Don't abandon stocks entirely: Even a compressed premium (1-2%) still means stocks will outperform bonds over 20+ years—you're just earning less excess return.

The test: if the equity risk premium falls below 1% and you're within 5 years of retirement, tilt toward bonds (60/40 → 50/50 or 40/60). If you're 30 years from retirement, ignore current premiums and stay the course (historically, compressed premiums mean-revert over decades).

Risk Premiums and Time Horizon: Why Stocks Win Long-Term

Risk premiums only matter if you have the time horizon to capture them. Over 1-year periods, stocks beat bonds ~60% of the time (the equity premium is unreliable). Over 10-year periods, stocks beat bonds ~80-90% of the time. Over 30-year periods, stocks beat bonds 95%+ of the time.

1-year rolling returns (1926-2025):

  • Stocks beat bonds: ~62% of years
  • Stocks lost money: ~27% of years (even with 10.4% long-term average)

10-year rolling returns:

  • Stocks beat bonds: ~85% of periods
  • Stocks never lost money over any 10-year period starting after 1942

30-year rolling returns:

  • Stocks beat bonds: ~98% of periods
  • Stocks beat bonds by average of 4.5% annualized

The point is: the equity risk premium is a long-term phenomenon. If you're investing for 1-3 years, the premium might not materialize (you could experience a -20% year). If you're investing for 20-40 years, the premium is nearly guaranteed.

The practical antidote: match asset class to time horizon. Cash for 0-3 years, bonds for 3-10 years, stocks for 10+ years. Don't hold stocks for 2-year goals (premium won't compensate for potential -20% drawdown). Don't hold cash for 30-year goals (you're forfeiting 6-7% annual real returns).

Detection Signals: You're Misunderstanding Risk Premiums If

You're likely miscalibrating risk and return if:

  • You expect 10% annual stock returns every year (ignoring that 10.4% is a long-term average with -37% and +37% years mixed in)
  • You hold 100% bonds for a 30-year retirement goal (forfeiting 4-5% annual equity premium, costing you ~$1.5 million on a $500k starting balance)
  • You panic-sell stocks during -20% drawdowns (realizing the volatility without capturing the premium)
  • You assume risk-free returns exist (even Treasuries have duration risk; only FDIC cash up to $250k is truly risk-free)
  • You demand 12% returns with bond-like volatility (impossible—high returns require accepting high volatility)

The test: if you want 7% real returns (necessary for most retirement plans), you need stock exposure of 70%+ given stocks' 7.2% real return and bonds' 2-3% real return. Anything less (60/40, 50/50) and you're implicitly accepting lower returns or extending your time horizon.

Practical Asset Allocation Based on Risk Premiums

Use historical risk premiums to reverse-engineer required asset allocation for your return target:

Example 1: 8% nominal return target (retirement in 30 years)

  • Stocks: 10.4% nominal
  • Bonds: 5.5% nominal
  • Solve: 0.10 × (10.4%) + 0.90 × (5.5%) = 6.4% (not enough)
  • Try 70/30: 0.70 × (10.4%) + 0.30 × (5.5%) = 8.9% (meets target with buffer)
  • Required allocation: 70% stocks / 30% bonds

Example 2: 5% nominal return target (conservative retiree)

  • Try 30/70: 0.30 × (10.4%) + 0.70 × (5.5%) = 7.0% (exceeds target)
  • Try 20/80: 0.20 × (10.4%) + 0.80 × (5.5%) = 6.5% (still above target)
  • Try 10/90: 0.10 × (10.4%) + 0.90 × (5.5%) = 5.99% (close)
  • Required allocation: 10% stocks / 90% bonds (or lower if accepting <5%)

The practical point: your return target dictates your risk exposure. If you need 9% returns but only tolerate 40% stocks, you have a strategy mismatch—either increase risk tolerance, lower return expectations, or extend time horizon.

Next Step: Calculate Your Required Equity Allocation

Single action: Determine the real return you need to hit your primary financial goal, then solve for the stock/bond mix required to deliver that return.

How-to:

  1. State your goal in real terms: "I need $2 million in today's purchasing power in 25 years"
  2. Calculate required real return using a financial calculator (inputs: PV = current savings, PMT = annual contribution, FV = $2M, N = 25, solve for I/Y)
  3. Add 3% inflation to convert to nominal return needed
  4. Use historical asset class returns to solve for allocation:
    • Stocks: 10.4% nominal
    • Bonds: 5.5% nominal
    • Formula: (Stock %) × 10.4% + (Bond %) × 5.5% = Required return
  5. Verify the allocation matches your risk tolerance (can you stomach -30% drawdowns?)
  6. If mismatch, adjust: (lower spending goal), (increase contributions), (extend time horizon), or (accept higher volatility)

The durable lesson: risk premiums aren't abstract—they're the mathematical bridge between your portfolio and your goals. A 40-year-old needing 8% real returns to retire at 65 must accept 80%+ stock allocation (and corresponding volatility). There's no way around it.

Sources:

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