Equity Risk Premium

Equity Risk Premium provides a much clearer way of understanding returns of equities as an asset class, leading to a better ability to forecast and manage risk, thus resulting in better portfolio construction. For example, if investors can objectively quantify the relative returns on stocks, bonds, and cash through risk premia, they can make better decisions on how to allocate their money across these three asset classes. If the equity premium is high, investors should allocate a larger portion of their assets to equities than if it is low.

The idea that riskier investments should deliver higher expected returns than less risky ones in the basis for all risk-return models in finance, and thus central to all asset allocation decisions. Thus, the Equity Risk Premium, i.e. the premium demanded by investors for investing in the stock market, is an essential input in both the Capital Asset Pricing Model (CAPM) as well as in asset allocation decisions involving equities. In the CAPM, market risk is measured by beta which when multiplied with the ERP gives the total risk premium for an asset or portfolio. Risk premia are central to competing risk return market models as well. For example, competing multifactor models measure risk by a series of betas each corresponding to the risk premium for an individual market risk factor.

The effects of estimating ERP are far reaching for investment managers as well as the global economy. Since assuming a high ERP of 7% will result in far greater investment in equities than, say, an assumption of 3%, underperformance of equity markets will result in significant losses for the fund. The consequences of this overestimation could be potentially far worse, for example, reduced corporate profits due to underfunding of their defined benefits pension funds, as well as increased taxes to meet fund shortfalls in case of large government funds. The importance of correctly estimating ERP is further enhanced by the fact that there

...