Equity Risk Premium
The Equity Risk Premium (ERP) is the return offered by an individual share over and above the Risk-Free Rate of Return (one can use either nominal (T-bills) or real rates (US TIPS) to generate the RFRR. It is the potential reward offered for taking the risk of investing in shares.
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How Is Equity Risk Premium Used In Trading?
The premium depends on the level of risk in the individual asset (the higher the risk, the higher the ERP will be).
It can be found by re-working the Capital Asset Pricing Model formula and establishes a link between the riskiness of an asset and its future return profile, using the asset’s Beta co-efficient as a proxy for its’ risk relative to that of the market.
As a general rule, the higher the equity risk premium, the higher future returns will likely be, as this then provides compensation for the risks associated with that investment going forward.
ERP Analysis
The ERP can only be estimated.
It is NOT an absolute number, nor is it static and it involves assumptions as to how that security will perform in the future, by assigning an expected rate of return for the market and a risk-free rate of return; deduct the latter from the former to get an ERP.
Geographic Variance
Each country will have a different ERP, as befits their different risk profiles.
In some markets (e.g. Greece), the ERP is considerably higher, at around 10%, (versus around 6% for the US), reflecting the economic disruptions the country has suffered in recent years.
Some believe one should have differing ERPs for different time horizons, with the range being around 3-3.5% over a shorter time period and as much as 5.5% per annum over a 30-year view, in the case of the US markets.
Historical Patterns
The expected return assumption can based on past historical return patterns (which may or may not repeat themselves).
Apart from merely extrapolating historical returns, one could use a re-working of the Gordon Growth Model to find a value for “g” (the future growth rate of dividends as a proxy for future growth) or take the earnings yield of an equity (the inverse of the P/E ratio, whereby a P/E of 20 equates to an earnings yield of 5%) as a growth forecast.
But neither of these measures allow for a change in valuations, implying that market peaks and troughs do not occur, which is clearly untrue.
Using any one of these methods one can set long term expectations for future returns of an asset and from that, decide on the asset allocation of an overall portfolio.
On this basis one might consider allocating more capital to equities as they generally provide higher per unit compensation for risk than do alternatives such as bonds.
However, at present, the higher ERP may be purely a function of the gap between expected market rate of return and risk-free rates widening; the long period of near zero risk free rates of return may not last indefinitely and thus the ERP may decline not due to any macro-economic factor (or market estimation of risk), but simply as the spread between the two metrics narrows.
This has led to abnormally high equity returns relative to bonds in the last 10 years or so, (implying a higher ERP than might be deemed appropriate), which has become known as the Equity Premium puzzle, to which no one has yet developed an adequate explanation.
The ERP can be a useful guide to future returns, but should not be relied upon as a forecast, as it relies heavily on all the formula’s components remaining stable, which they do not.
A high ERP may be an indication of high future returns, but there are no guarantees.