The Five Risk Premiums
This post was written by Associate Wealth Advisor, Arman Hundal.
Vince recently shared that his own investment portfolio is built around two core funds: Dimensional Global Equity (mutual fund code DFA606 or 607) and Vanguard Global Momentum (Ticker VMO). At a high level, these funds are designed to capture what are commonly known as the big five risk premiums.
Instead of getting technical with finance terms, my goal is to explain, in plain English, what these premiums are, why they exist, and why they matter.
Before getting into the details, let me clarify what I mean by “risk.” Risk does not mean markets going up and down – that’s volatility, and volatility is normal and unavoidable. The risk I’m describing is the one that shows up when investors make poor decisions, abandon plans, or fall short of their long-term goals.
The reason risk premiums exist is because living through uncertainty can be uncomfortable and staying disciplined is harder than it sounds.
Market Risk Premium
The market risk premium sits at the core of investing. It’s the additional return investors expect for owning equities instead of holding risk-free assets like cash.
Equities move. Sometimes they fall without reason. The experience is unsettling, but it’s not a defect in the market: it’s the cost of participating in long term growth.
If owning equities felt calm and predictable, there would be little reason for them to offer higher returns.
This premium exists because uncertainty is uncomfortable. Investors who withstand volatility have been rewarded over time. Those who react emotionally often lock in losses and miss the recovery.
This matters because long term growth depends on tolerating short term discomfort.
Small Company (Size Premium)
Over extended periods, smaller companies have outperformed larger companies, particularly when those companies are profitable.
That doesn’t mean smaller companies are better businesses. Smaller companies have less diversified business models, are more sensitive to economic slowdowns, and have limited access to capital.
Compare a company like Shake Shack to McDonald’s. McDonald’s operates globally. It has stable cash flows, diversified revenue streams, and significant financial resources. Shake Shack, while a strong brand, is much more exposed to economic conditions, has fewer locations, and less margin for error.
Because of that, investors expect a higher return for owning small companies. The size premium reflects that trade off.
Being small isn’t enough. Many small companies are small because they are lower quality businesses. What’s historically been more meaningful is the combination of size and profitability. This is why Dimensional (of Dimensional Global Equity) focuses on small and profitable companies.
This premium requires patience. Those willing to "hang in there" should benefit long term.
Value Premium
The value premium suggests companies trading at lower prices relative to their fundamentals (like earning, book value, cash flow) should outperform more expensive growth companies.
Think of a business that looks like it should be $8/share because of its fundamentals trading at $6. That discount usually exists for a reason, such as bad headlines, uncertainty about the future, or recent poor performance. In other words, it feels risky to own undervalued companies. They might be undervalued for a reason.
Value stocks are often unpopular. They may be dealing with short term issues, negative headlines, or slower growth. They also tend to look even worse during difficult economic periods, which adds to the discomfort of owning them. As a result, owning them rarely feels good when markets are enthusiastic about companies that look exciting.
That discomfort is why higher returns have been available. Investors demand extra compensation to hold businesses that are out of favour. Over time, many of these companies stabilize or surprise to the upside.
Value investing has had a difficult run for much of the past decade, significantly underperforming growth investing. But over longer stretches of history it has been a strong contributor to returns. When or if that leadership returns is uncertain. That’s the point.
This matters because discipline is hardest when an investment feels unloved. Historically, that is when patience has mattered most.
Profitability Premium
The profitability premium reflects the tendency for companies with strong and consistent profits to outperform companies with weaker or less reliable profitability.
Profitable companies have more options. They can reinvest internally, are less reliant on borrowing and are better able to withstand economic pressure.
A company generating consistent profits can fund its own growth, while a less profitable company may depend on outside financing, leaving it more vulnerable if conditions change.
Markets have not always reflected this strength particularly well, especially in smaller or more value oriented stocks.
Over the long term, an emphasis on quality fundamentals has led to greater returns without the need to make market predictions.
Momentum
Momentum captures a simple market reality. Stocks that have been performing well often continue to do well over shorter periods, while lagging stocks frequently keep lagging. While momentum can be controversial, we include it because history suggests it works (especially when value investing is out of favour).
Why this happens is still debated. Some view momentum as a risk premium, while others believe it reflects investor behaviour.
In practice, it likely has a lot to do with how people process information. Markets do not adjust instantly. When new information comes out, investors tend to react gradually. Expectations shift over time, and prices often move in trends rather than all at once.
Momentum is not about forecasting or trying to get clever. It is about acknowledging how markets behave in practice.
Ignoring this dynamic can mean working against patterns that have persisted for decades.
How We Incorporate This Into Portfolios
These five risk premiums are implemented through what we refer to as our equity model. The structure is intentionally straightforward.
- 80% Dimensional Global Equity Fund
- 20% Vanguard Global Momentum Fund
Together, these funds provide broad diversification while deliberately targeting the five risk premiums discussed above. The approach avoids market timing and does not rely on short term predictions.
The goal is not to avoid volatility. That would be unrealistic for long term investors. Instead, the objective is to take risk deliberately, with a clear plan and a disciplined process.