Wednesday’s Word: Equity Risk Premium

By Tosha Dunn, Spring 2016 Student Intern

When investors select a stock, part of the calculus involved is the determination of risk associated with the investment. The risk of the investment, among other things, suggests the return that the investor can expect. Usually, a riskier investment is expected to provide a higher potential return, but you may wonder what’s behind that generality.

First, there are two variables at work: there’s the risk free rate and there’s the equity risk premium (ERP). The risk free rate is the return an investor would receive if he were to purchase what are considered no risk bonds, like Treasury Bills. T-Bills are short-term bonds issued by the U.S. government, and they generally offer low rates of return (a 1 year note currently offers a 0.47% return). However, the reason T-Bills are considered to be ‘no risk’ is because they are backed by the United States, so an investor will always have their principal investment returned. And when you know that you can invest saved funds and expect that a year later they will be returned (plus a little extra) virtually without fail, then you are facing no risk.

Now, for the second, admittedly tricky, part of the equation, the ERP. To induce investors to purchase stock instead of no risk bonds, stocks have to offer a return that makes the investor indifferent between holding the bond and holding the stock. Yes, that is a sentence you may want to read more than once. So here’s an example.

Assume we have Jane, and Jane wants to invest. Jane looks at T-Bills and sees that she can recover all of the money she invests plus interest within a year with no thought associated. She also looks at stocks and notices that they offer a much higher return. But for Jane, the return on a stock has to be high enough that it compensates for the associated risk. In fact, the return has to be high enough that when Jane is considering the bond versus the stock, she could go either way. What this means is that the return on the stock is so high that it outstrips Jane’s risk aversion. And that is the Equity Risk Premium. It’s the amount that has to be paid over and above the risk free rate for an investor to no longer factor risk into his decision about investing in a particular instrument.

If you want to more information about Treasury Bond yields, you can view their daily yields. And if you are very interested in learning more about risk aversion, Beyond Risk Seeking and Risk Aversion, provides a general idea of the economic theories that inform the term, and it offers a behavioral explanation for risk aversion, as well. For some very high brow explanations of the Equity Risk Premium and its overall meaning within the market, the Federal Reserve Bank of New York offers The Equity Risk Premium: A Review of Models, which explains the ERP and discusses various models (over 20!) that are used to calculate this important economic indicator.