Increased risk to capital should be rewarded with a higher rate of return. Some short-term money market instruments (for example, three-month Treasury bills) are characterised as ‘risk-free’ due to the presumed safety of the principle sum invested. Share prices, on the other hand, are volatile and there is a greater likelihood of suffering nominal losses. The chance of higher returns is compensation for this risk and, over time, equities have beaten many other asset classes. The margin by which the average annual performance of stocks outshines that of risk-free assets is the equity risk premium (ERP).
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