How to evaluate the expected return based on the risk level of your investment

Key Aspects

• The additional return you seek when investing in volatile assets compared to safe options defines your investment strategy.
• The market risk premium varies according to factors such as volatility, the debtor's ability to pay, and the ease of liquidating positions.
• Mastering this concept allows you to build a balanced portfolio that fits your risk tolerance.

Why does the market demand higher returns for taking on risks?

When you decide to put money into volatile investments, there is a fundamental expectation: there must be an economic incentive that compensates for that uncertainty. This incentive is expressed as the additional return you will receive compared to safer options.

Let's take a practical example: if a U.S. Treasury bond yields 2% annually while a corporate stock offers 5%, those extra 3 percentage points represent the “risk premium” you are asking for. It's the difference between what you earn in the safe versus what you expect to gain in the risky.

This concept explains why in cryptocurrency markets the potential returns are significantly higher than traditional bonds or stocks. Bitcoin, although considered the most stable option within the crypto ecosystem, still carries extreme volatility compared to conventional assets. Altcoins, for their part, present exponentially greater risks: uncontrolled price fluctuations, abrupt regulatory changes, rug pull risks, security vulnerabilities, and constantly changing market narratives.

The different components of expected return

There is no single type of risk compensation. Each investment category has its own incentive structure.

The equity risk premium arises because company prices fluctuate more than safe bonds. Shareholders demand higher returns because their investments are more sensitive to economic changes.

The credit risk premium appears when you lend money to entities that may not pay it back. A company with unstable finances must offer higher rates to attract loans. The risk of default is real, which is why the market compensates.

The liquidity risk premium applies to assets that are difficult to sell quickly, such as specific real estate or collectibles. If something cannot be easily converted into cash when needed, it must offer higher returns to justify that illiquidity.

In the cryptocurrency market, these three primes combine and amplify. The ecosystem is young, highly volatile, regulations are unpredictable, and liquidity varies greatly depending on the asset. That's why potential returns are so much higher.

How professionals measure this risk-return relationship

Analysts use sophisticated models like the Capital Asset Pricing Model (CAPM) to estimate what return an investment should offer considering its level of systematic risk. This model helps to answer: Is this return fair for the risk I am taking?

The basic calculation is straightforward: you take the expected return of the risky asset and subtract the return of the safe investment. If you believe a stock will generate an 8% annual return and the safe bond pays 3%, then the premium is 5%. That 5% is what the market considers adequate compensation for that specific level of uncertainty.

However, these numbers are not fixed. The market risk premium constantly fluctuates according to the economic context, market sentiment, and the particular characteristics of the asset.

Factors that cause compensation expectations to change

Risk premiums move all the time. When the economy faces uncertainty, investors demand higher compensation because the probability of loss increases. In periods of stability, they settle for lower compensations because the perceived risk is lower.

The overall macroeconomic health is crucial. Events such as financial crises, changes in monetary policy, or political instability dramatically alter how much extra investors want to earn for taking on risks.

It also deeply influences how new, volatile, or illiquid the investments in question are. Altcoins experience greater changes in their risk premiums than Bitcoin precisely because they are less known, harder to sell, and more unpredictable.

Building an Informed Strategy

Understanding the risk premium allows you to make more informed decisions. The goal is not to always seek the highest return, but to balance opportunity with risk according to your personal profile.

Diversifying among assets with different risk premiums is the classic technique. By combining stable investments with higher risk-return opportunities, you can seek growth without exposing yourself catastrophically. The correct balance depends on your financial goals and how much volatility you can psychologically tolerate.

A well-constructed portfolio recognizes that each type of investment offers a different compensation for its specific uncertainty. The smart thing to do is to consciously choose how much risk premium you want to take on and in what magnitudes.

The final message

If you are looking to achieve attractive returns, you will almost inevitably have to take on additional risks. The key is to understand them, quantify them, and deliberately decide if that trade-off is worth it for you.

Mastering the concept of risk premium makes you a more sophisticated investor, capable of evaluating opportunities from an appropriate risk-return perspective.