Imagine you’re considering two investment options. One is stable, considered relatively safer, and offers a modest return. Think government bonds or a money market fund. Your other option is to invest in the stock market. The potential for gains is greater but that potential comes with risk. Not only could you fail to generate a return, but you could also even lose money.
Why would an investor choose the riskier path? The answer to this question lies in something called the equity risk premium.
The equity risk premium is the excess return that investors expect for taking on the uncertainty of investing in stocks rather than sticking to less volatile options like government bonds.
The equity risk premium is ubiquitous in the investing world; it underlies everything from the rationale behind your 401(k) portfolio asset allocation to how investment professionals forecast future returns.
Understanding the equity risk premium can empower you to help make smarter investment decisions, whether you’re evaluating your portfolio or making a long-term financial plan.
Since the equity risk premium is the excess return an investor expects from investing in stocks rather than low-risk bonds, it makes sense that calculating the premium would start with identifying what’s called the risk-free rate.
In the investment world, it’s standard practice to use the rate paid on the 10-year government Treasury note, which is widely considered to be the “safest” investment one can make.1 Treasury securities are described as considered the least risky since the idea of the United States defaulting on its obligations is virtually unthinkable. No other type of fixed income security is regarded to have lower risk, although bonds like AAA-rated corporates issued by Blue Chip companies are considered to be very low risk.
If you want to calculate the equity risk premium you need a few key pieces of information:
Rf = the risk-free rate
Rm = the expected return on the market
Equity risk premium = (Rm- Rf)
In the equity risk premium calculation, the market return is typically determined by using the historical or expected return of an index such as the S&P 500, which is generally considered to be a proxy for the overall stock market.
Let’s say the 10-year treasury is at 4.407%2 annually while the stock market has averaged an annual return of around 10% over the last century, as measured by the S&P 500.3 In this case, the equity risk premium would be the market return of 10% minus the 10-year treasury’s 4.407%, or approximately 5.59%. The 5.59% represents the additional return over the risk-free rate that stock investors demand for bearing the risk that comes with equities.
But here’s the kicker: in the example above, we calculated the equity risk premium using the historical market return. The equity risk premium is only useful in investment decision making when it’s forward-looking. If we’re using the equity risk premium as a theoretical tool to inform investment decisions, we need an estimate of how much the market is expected to grow in the future. You can make a prediction based on historical averages, or you can look at publicly available forecasts published by investment firms.
However you choose to make the calculation, you can then compare the equity risk premium to your required rate of return. If the equity risk premium is lower than your required rate of return, you may want to reconsider investing in stocks and look for alternative investments.
Similarly, if you want to calculate the equity risk premium for an individual stock rather than the overall market, use the expected return for the stock. For a forward-looking calculation, you can estimate a stock’s expected return by using historical average returns or analyst estimates.
As we discussed in our piece on the capital asset pricing model (CAPM), beta is often used as a proxy for risk because it describes the investment’s volatility relative to the market.
A beta of 1 indicates that a stock moves in lockstep with the market. A beta greater than one indicates that the security is more volatile than the market, while a beta of less than one indicates that it is less volatile.4
You can calculate the equity risk premium using beta to incorporate a stock or portfolio’s risk relative to the market. Let’s try an example with an individual stock.
The equity risk premium (or expected return on Stock A) = βa(Rm- Rf) where:
Rf = the risk-free rate
Rm = the expected return on the market
βa = the beta of Stock A
As an example, assume a risk-free rate of 4% and a market return of 10%. Stock A’s beta is 1.5.
Therefore, 1.5(10–4) = 9. Stock A must generate a return of 9% or higher to justify its level of risk.
Financial theory is nice to know, but what’s important to the average investor is how to use it to make better decisions. The equity risk premium can play an important role in several ways.
Making investment decisions: The equity risk premium gives you a benchmark to evaluate your potential returns from stocks versus relatively safer investments like bonds. If the equity risk premium is relatively high, it may imply greater long-term rewards for investing in equities. Conversely, a low ERP could suggest that stocks may not offer enough extra return to justify their higher risk at the moment.
You can also use a risk premium to look beyond individual stocks and consider the overall premium that would support a decision at the asset class level. The market risk premium tells an investor how much excess return they need to invest in equities as an asset class rather than in low risk government bonds.
As mentioned above, comparing the equity risk premium to your required rate of return can inform investment decisions. When the equity risk premium is higher than your required rate of return, consider investing in stocks. If it’s lower than your expected rate of return, investing in stocks becomes less attractive as the return won’t likely justify the risk.
Understanding market expectations: The equity risk premium reflects the collective expectations of the investment community. When it increases, this typically signals a more risk-averse market with investors demanding higher returns to hold stocks. When it decreases, markets could be more optimistic and require less compensation for assuming risk.
Keeping tabs on the ERP can offer insight into current market sentiment. Standard & Poors offers a U.S. Equity Risk Premium Index that measures the spread of returns of U.S. stocks over long-term government bonds. If you notice that the risk premium is narrowing significantly, it could signal that stocks are overvalued or that investors are overly optimistic.
Aligning risk tolerance with portfolio strategy: Every investor’s risk tolerance is unique, shaped by factors like age, income, financial goals, and temperament. If the equity risk premium is high, investors with higher risk tolerance will be more inclined to invest. Conservative investors might be more comfortable with safer assets. If you understand the ERP, you can better align your investments with your appetite for risk.
Portfolio diversification: A smart investor knows the value of diversification. Even if equity offers higher returns, it’s generally unwise to put all your money in one asset class. The ERP can help guide your diversification strategy by clarifying how much of your portfolio should be allocated to stocks vs bonds.
For example, if the ERP is historically high, a balanced portfolio with more equity exposure might make sense. If it’s low, you might think about increasing your weighting to bonds.
Identifying periods of growth or risk: A shrinking or volatile equity risk premium can portend changes in the market. If rising, the ERP could indicate opportunities to buy undervalued stocks amid bearish conditions. Conversely, if declining, it could suggest an overvalued market.
The equity risk premium is more than just financial jargon; it’s a powerful concept to help retail investors make informed decisions. If you understand ERP, how it’s calculated, and its implications for market expectations, you can better evaluate potential returns, fine-tune your portfolio strategy, and balance risk and return.
Whether you’re new to investing or working on optimizing your portfolio, keeping an eye on the equity risk premium is a step toward making better, more data-driven decisions. Remember that while ERP is an important tool, it’s only one part of the bigger picture.