What is Equity Risk Premium?
The term equity risk premium refers to an excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing. The size of the premium varies and depends on the level of risk in a particular portfolio. It also changes over time as market risk fluctuates.
An equity risk premium is an excess return earned by an investor when they invest in the stock market over a risk-free rate.
This return compensates investors for taking on the higher risk of equity investing.
Determining an equity risk premium is theoretical because there’s no way to tell how well equities or the equity market will perform in the future.
Calculating an equity risk premium requires using historical rates of return.
How Equity Risk Premiums Work
Stocks are generally considered high-risk investments. Investing in the stock market comes with certain risks, but it also has the potential for big rewards. So, as a rule, investors are compensated with higher premiums when they invest in the stock market. Whatever return you earn above a risk-free investment such as U.S. Treasury bill (T-bill) or a bond is called an equity risk premium.
An equity risk premium is based on the idea of the risk-reward tradeoff. It is a forward-looking figure and, as such, the premium is theoretical. But there’s no real way to tell just how much an investor will make since no one can actually say how well equities or the equity market will perform in the future. Instead, an equity risk premium is an estimation as a backward-looking metric.
It observes the stock market and government bond performance over a defined period of time and uses that historical performance to the potential for future returns. The estimates vary wildly depending on the time frame and method of calculation.
Calculating Equity Risk Premium
Equity Risk Premium (on the Market) = Rate of Return on the Stock Market − Risk-free Rate
Here, the rate of return on the market can be taken as the return on the concerned index of the relevant stock exchange, i.e., the Dow Jones Industrial Average in the United States. Often, the risk-free rate can be taken as the current rate on long-term government securities.
Historical Risk-Premium Factors
The U.S. stock market has averaged a 10-year return of 9.2%, according to research by Goldman Sachs, with a 13.6% annual return in the trailing ten years from 2020 pre-COVID (Source: Capital IQ).
In the same time horizon between 2010 and 2020, the 10-year Treasury note remained in the 2% to 3% range.
There are numerous factors that can impact equity risk premiums, such as:
- Macroeconomic Volatility
- Geopolitical Risks
- Governmental and Political Risk
- Catastrophic Risk and Disasters
- Low Liquidity
Interpretation of Equity Risk Premium
We know the risk associated with debt investment, as the investment in bonds, is usually lower than that of equity investment. Like that of preferred stock, there is no surety of receiving the fixed dividend from the investment in equity shares as the dividends are received if the company earns a profit and the dividend rate keeps on changing.
People invest in equity shares, hoping that the value of the share will increase shortly and they will receive higher returns in the long term. Yet there is always a possibility that the value of a share may decrease. This is what we call the risk that an investor takes.
Moreover, if the probability of getting a higher return is high, the risk is always high. If the probability of getting a smaller return is high, then the risk is always lower, and this fact is generally known as a risk-return trade-off.
The return that an investor on a hypothetical investment can receive without any risk of having financial loss over a given period is known as the risk-free rate. This rate compensates the investors against the issues arising over a certain period like inflation. The rate of the risk-free bond or government bonds having long-term maturity is chosen as the risk-free rate as the chance of default by the government is considered to be negligible.
The riskier the investment, the more is the return required by the investor. It depends upon the investor’s requirement: risk-free rate and equity risk premium help determine the final rate of return on the stock.
Advantages and Drawbacks
Using this premium, one can set the portfolio return expectation and determine the policy related to asset allocation . For example, the higher premium shows that one would invest a greater portfolio share into the stocks. Also, CAPM relates the stock’s expected return to equity premium, which means that a stock with more risk than the market (measured by beta) should provide an excess return over and above equity premium.
On the other hand, the drawback includes the assumption that the stock market under consideration will perform in the same line as its past performance. No guarantee is there that the prediction made will be real.
This gives the prediction to the stakeholders of the company that the stocks with high risk will outperform when compared with less risky bonds in the long-term. There is a direct correlation between risk and the Equity risk premium. Higher the risk will be the gap between the risk-free rate and the stock returns, and hence premium is high. So it is a very good metric to choose stocks worth the investment.