A risk premium is the minimum difference a person requires to be willing to take an uncertain bet, between the expected value of the bet and the certain value that he is indifferent to.The equity risk premium is commonly viwed as the extra retun needed to induce investors to risk their money in the stock market rather than opting for the safe haven of government bonds.It is a simple theory based on common sense.
In theory, stocks should provide a greater return than safe investments like Treasury bonds. The difference is called the equity risk premium: it is the excess return that you can expect from the overall market above a risk-free return. There is vigorous debate among experts about the method employed to calculate the equity premium and, of course, the resulting answer. In this article, we take a look at these methods – particularly the popular supply-side model – and the debates surrounding equity premium estimates.
Why Does it Matter?
The equity premium helps to set portfolio return expectations and determine asset allocation policy. A higher premium, for instance, implies that you would invest a greater share of your portfolio into stocks. Also, the capital asset pricing relates a stock’s expected return to the equity premium: a stock that is riskier than the market – as measured by its beta – should offer excess return above the equity premium.
Greater Expectations
Compared to bonds, we expect extra return from stocks due to the following risks:
1. Dividends can fluctuate, unlike predictable bond coupon payments.
2. When it comes to corporate earnings, bond holders have a prior claim while common stock holders have a residual claim.
3. Stock returns tend to be more volatile (although this is less true the longer the holding period).
And history validates theory. If you are willing to consider holding periods of at least 10 or 15 years, U.S. stocks have outperformed treasuries over any such interval in the last 200 years.
But history is one thing, and what we really want to know is tomorrow’s equity premium. Specifically, how much extra above a safe investment should we expect for the stock market going forward? Academic studies tend to arrive at lower equity risk premium estimations – in the neighborhood of 2-3%, or even lower! Later in this article, we’ll explain why this is always the conclusion of an academic study, whereas money managers often point to recent history and arrive at higher estimations of premiums.
Very useful article.