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What is the equity risk premium?

Photo of Lars Kroijer hedge fund manager turned passive index investing author

This post on the equity risky premium is from former hedge fund manager turned author Lars Kroijer, an occasional contributor to Monevator. He also wrote Investing Demystified.

How much should we expect to make when we put our money into shares – preferably by investing globally with a world tracker fund?

In my opinion, our expectation should be driven by our view of the equity risk premium.

And what is the equity risk premium?

The equity risk premium is a measure of how much extra return investors in the stock market expect to be paid for taking on the additional risk of investing in shares, compared to if they’d invested instead in the minimal risk asset.

The minimal risk assets in the UK and US are those countries’ domestic government bonds.

Shares are much more risky than UK and US government bonds, but everything has a price.

That price is the equity risk premium.

What is the equity risk premium, in numbers?

When we look to the equity risk premium as passive investors – or as I like to say, as rational investors – we’re not trying to predict whether the prospects for the markets are particularly good or bad right now.

The equity risk premium simply acknowledges that historically, investors have demanded a premium for investing in risky equities, as opposed to instead investing in less risky assets.

By using the equity risk premium in our calculations, we’re saying we presume investors will expect to be paid a similar premium for investing in equities going forward to what they’ve demanded in the past (unless the risk of those markets has changed substantially compared to the past).

How much is that premium?

The size of the equity risk premium is subject to much debate, but something in the order of 4-5% is what you’ll typically see quoted.

If you study the performance of the global equity market over the past hundred years or so, the average annual compounding rate of return over that period is within this range.

Real returns 1900–2015

World equities 5.2%
Short-term US government bonds 0.9%
Equity risk premium 4.3%

Source: Credit Suisse Yearbook 2015

Of course it’s impossible to know if the markets since 1900 were particularly attractive or poor for equity holders, compared to what the future has in store.

The equity risk premium is not a law of nature, and it will change over time as the data changes.

When I published my book, for instance, the same calculation we’ve just done produced a slightly higher equity risk premium of 4.5%, using returns over the period 1900 to 2011.

There is also some evidence that the risk premium changes with the level of risk (or volatility) in the markets – that is, that those brave enough to enter the markets at times of maximum turmoil and risk are rewarded with higher expected returns.

In general academics say there aren’t enough datapoints to make this argument convincingly, but the evidence does point in that direction.

Could the equity risk premium be different in the future?

The equity risk premium is simply an expectation of future returns.

There are various ways to calculate it, but here we’ve simply based it on what stock markets have achieved in the past – including all the booms and bear markets along the way.

To be sure, economists and finance experts disagree strongly on what we should expect going forward.

And some do consider this kind of projecting by looking in the rear-view mirror approach to be wrong.

But I disagree.

In my view the long and volatile history of equity market returns gives a good idea of the kind of returns we can expect going forward, provided we don’t try to be too precise.

Equity market investors have previously demanded a 4-5% return premium for taking on the kinds of risks equities entail, and assuming that those risks remain roughly similar to what they were in the past, it’s reasonable to assume a similar return expectation from here.

So I think there’s a good probability that going forward investors will demand a similar 4-5% return premium for a similar kind of risk.

Next week we’ll look at what the equity risk premium means for your portfolio. I’ve turned off reader comments for this first article, so we can have the discussion in one place then.

Lars Kroijer’s book is Investing Demystified. Lars is donating all his profits from his book to medical research. He also wrote Confessions of a Hedge Fund Manager.