What is Equity Risk Premium?

The equity risk premium is like shooting a three-pointer in basketball…

In basketball, ordinary baskets are worth two points. But if you make shots from further away, beyond a line painted on the court, you get three points. You’re taking on more risk of missing the basket than if you had shot from closer to the basket, so you get more points if you make the shot. Similarly, the equity risk premium is the extra return you could get for putting your money into stock investments with greater risk than very low risk investments.

Equity risk premium refers to the higher expected return from the stock market, above and beyond the essentially risk-free rate of return you could earn by investing in U.S. government securities. It’s a reason for investors to put their money in stocks, despite the higher risk such investments carry - they have the chance to make higher returns than they would by playing it ultra-safe and sticking to the guaranteed returns of Treasury securities.

The equity risk premium is constantly changing, since stock market returns vary daily. Investors can either look to what the equity risk premium has been based on past data, or they can use current numbers to estimate what it will be in the future.

Two factors go into calculating the equity risk premium for a particular time period: the stock market’s returns and the rate of return of risk-free securities.

Stock market return numbers are often based on either the S&P 500, a financial index which tracks the performance of 500 leading U.S. publicly traded companies, or the Dow Jones Industrial Average, which tracks 30 of the most prominent U.S. public companies.

Analysts use the S&P 500 because it provides a broader picture of the entire stock market’s performance. But returns can vary - in a recession, investors might see their returns slip, but if the economy is growing, returns might be especially high.

The risk-free rate of return generally refers to the return that investors get from U.S. Treasury securities issued and guaranteed by the federal government.

Every type of investing includes some level of risk. Even nominally “risk-free” securities issued and guaranteed by the federal government have some risk - the risk that their returns won’t keep up with inflation, and that investors won’t be able to resell them on a secondary market at a profit.

In general, investing in the stock market (buying equity or an ownership share in publicly traded companies) is riskier than buying government securities. Because of that extra level of risk, investors also expect to see a greater return. The equity risk premium is basically the bonus investors hope to get for taking on the additional risk of investing in stocks. The risk premium isn’t a guarantee - along with the possibility of higher returns than they would get from risk-free investments, investors in the stock market also run the risk of losing some or all of their investment.

The historical equity risk premium is the average difference between the stock market’s return (usually based on the S&P 500) and the return of risk-free government securities over a period of time. Calculating it is simpler than trying to project what it will be going forward, since the historical premium is based on what’s already happened. But there’s no guarantee that past data will accurately predict the future, so historical returns should be used with care when making future investment decisions.

You can use this formula to figure out the historical equity risk premium:

Historical Equity Risk Premium = Average Stock Market Return — Average Risk-Free Return

Suppose you want to calculate the historical equity risk premium for the 25 years leading up to 2020. The average S&P 500 return for that period was 9.74%. The average 10-year Treasury rate for that same period was 3.8%. When you subtract the risk-free rate from the S&P 500 return, you find that the historical equity risk premium for that period was 5.94%.

The implied equity risk premium is a calculation of the risk premium that looks forward instead of back. Rather than measuring what the equity premium was in the past, calculations for the implied equity risk premium estimate what it will be in the future. It may be a more relevant calculation, since it doesn’t just assume the stock market will behave in the future the same as it did in the past, but it’s also more speculative, since we can’t know exactly what future performance will be like.

To calculate the implied equity risk premium, you take the estimated future return on stocks and subtract the expected future risk-free rate of return. Many investors forecast future returns on stocks by looking at factors like their projected future earnings and the expected growth in the dividends they pay, since those will add to the value you reap as an investor.

But projecting future returns isn't easy, and it's inherently speculative - and thus, so is calculating the implied equity risk premium. It involves making assumptions that might or might not be correct, so there’s room for error. And projections about the future can change quickly and dramatically, because of factors like market psychology or unexpected news at a company or in the broader stock market or the economy. So investors should be cautious about expecting estimates of the implied equity risk premium to be precisely correct.

Equity risk premium (aka equity market risk premium) refers to the greater return that an investor expects to get for taking on risk when investing in stocks, because it carries more risk than investing in risk-free government securities. Market risk premium is a similar concept, but broader: It refers to the added return and risk involved in investing in a diversified portfolio.

Suppose you compare the risk and return of two different investors. Susan invests only in U.S. government bonds. She takes on very little risk because the U.S. Treasury Department backs the bonds, but she also expects only a modest return.

The other investor, Robin, puts her money into many different types of assets, like individual stocks, bonds, real estate, and index funds (funds that track the performance of a particular financial index). Robin is taking on more risk than Susan - stocks, bonds, real estate, and index funds all carry some level of risk - but she also expects a greater return as a trade-off for that risk. The greater return that Robin expects to get is the market risk premium. If Robin had invested only in stocks rather than in a variety of assets, her greater return would be an equity risk premium.

It’s important to note that diversification doesn’t protect an investor from financial losses or guarantee any sort of profit. While its purpose is to reduce some of the losses, it’s not a guarantee.

The equity risk premium fluctuates with the market. When the stock market is having a particularly good year, the premium might be higher; when it’s having not as good a year, the premium might be lower.

2020 was a particularly volatile year for the market as a result of the COVID-19 outbreak and its effect on the economy, so the equity risk premium was volatile as well. Data from the Stern School of Business at New York University shows the equity risk premium was 4.72% as of January 2021.