The concept of the Equity Risk Premium (ERP) is typically used in share market investments, but I believe investors should apply a similar approach to all investment decisions. To ensure investors are adequately rewarded for the risk they take, I like to think of it as the Investor Risk Premium.
What is the equity risk premium?
Put simply, the ERP is the extra return investors expect from the share market compared to a risk-free investment, like government bonds. It’s essentially the reward for taking on the uncertainty of the share market. Risk, in this context, means the chance that your returns may fall short of expectations, whether in a single year or over the long term.
Historical average
The average ERP in the US since September 2008 was approximately 5.4% as depicted in the chart below. The ERP in Australia is similar to the US as the long-term trend typically ranges between 5.5% and 6.5%.
What affects the ERP?
As the chart above shows, ERPs have ranged between 4% and 7.5%. They are impacted by several factors, including:
- Market conditions: When there’s uncertainty and volatility in the market, whether due to political events, economic disruptions, or unexpected crises, investors typically demand a higher ERP as compensation for taking on more risk. Government policy uncertainty also plays a big role, as unclear or changing policies can make future returns harder to predict, increasing perceived risk.
- Economic factors: Strong economic growth, low inflation, and stable earnings growth generally lead to a lower ERP, as investors feel more confident about future returns. On the flip side, if economic growth slows down or inflation picks up, investors tend to demand a higher premium to compensate for the increased risk of lower returns.
- Market risk sentiment: The “risk on” vs “risk off” mentality, has a significant impact. When investors are feeling optimistic, sometimes even over-optimistic, which is what is called “risk on”, they are more willing to accept lower ERPs because they are more comfortable with the potential for growth. However, when sentiment shifts to “risk off,” meaning investors are more cautious, they demand higher ERPs to justify the uncertainty and potential downside risks in the market. All these factors come together to shape the level of the equity risk premium at any given time.
Expected future returns from various geographical markets
The table below compares expected 10-year stock market returns in domicile currencies to their respective risk-free rates to estimate forward expected ERP.
The key takeaway from this data is that the US share market does not appear to offer investors enough reward for the risk. Valuations are extremely stretched. The US CAPE ratio is sitting at 36.8, more than double its long-term median of 16.5! In contrast, Australia’s CAPE ratio is only slightly elevated at 17.8 versus a median of 16.7.
Another key observation is that ERPs are below their long-term average of 5.5–6.0% globally. Some may argue this could be due to structural shifts like AI, technology or stronger monetary policy support from central banks over the past decade, potentially leading to a permanently lower ERP. But I’m always sceptical of claims that fundamental indicators like ERP have changed forever. History has proven these predictions wrong time and time again. More likely, today’s lower ERP is simply a result of overvalued stock markets, especially US large-cap stocks!
For investors, the message is clear: investing via traditional market cap indexing may not be worth the risk right now, as I discussed earlier this year.
Also, when assessing future expected returns, it’s important to consider them in Australian dollar terms, unless the investment you are contemplating is largely currency-hedged. On that basis, expected 10-year annual returns are: US 1.8%(!), Australia 7.6%, Europe 6.8%, Japan 8.6%, and the UK 7.1%. These expected returns reflect the fact that the Australian dollar is relatively weak at the moment.
Apply this concept to all investments
History shows that investors typically expect to earn around 5.5% p.a. above the risk-free rate to justify investing in the share market. Compared to many other asset classes, shares have lower-risk attributes, such as:
- Share markets are heavily regulated in developed markets,
- many stocks are highly liquid, and
- they benefit from transparent price discovery, where buyers and sellers openly bid based on all publicly available information, like a real-time auction.
However, the trade-off is volatility. Stocks tend to have annual volatility of 18% to 20%, which means that although the long-term average return is around 10% p.a., in any given year, 95% of the time your returns can range from -30% to +50% (within two standard deviations). That’s a massive range!
Given this, if we are investing in an asset class that lacks liquidity, strong regulation, or transparent price discovery, we should demand a higher return to compensate for the additional risk. Conversely, if an investment is less volatile, we might be willing to accept a lower return.
Right now, the risk-free rate (10-year government bond rate) is 4.4% p.a. To justify investing in shares, I need to expect a total future long-term return of at least 10% p.a. And I believe residential property investors should expect similar returns to invest in property. However, if you are investing in speculative stocks or crypto, you should aim for at least two to three times higher returns to compensate for the extra risk.
Looking at past performance, the U.S. market has returned over 13% p.a. over the last decade, while the Australian share market has lagged at 7.6% p.a., meaning U.S. investors have been well rewarded, while Australian share market investors have not. But what matters most is future returns, not past performance.
This is theory – what happens in practice is sometimes different
Despite reliable indicators suggesting that share market index investors may not be adequately compensated over the next decade, plenty of people are still piling in. Why?
In the short term, markets do not always behave rationally. Sentiment tends to drive prices in the short run, while fundamentals take over in the long run. But markets can stay irrational for far longer than most expect.
Since early 2009, the US market has delivered an average return of over 14% p.a., marking the longest bull run in its history. For S&P 500 investors to continue being adequately compensated, the market would need to sustain this trajectory. While that’s possible, the longer the rally continues, the less likely it becomes.
Conversely, Australian share market and property has underperformed over the past one to two decades.
Are you ensuring that you will be compensated for risk?
The key takeaway is this: always consider both risk and future expected returns. Do not get caught up in past performance and overlook the risks. The goal of investing is to achieve the highest possible return for the lowest level of risk.
If you are investing in the stock market, it’s important to understand where the risks lie, such as heavy concentration in large-cap stocks (as I’ve discussed here), and adjust your strategy accordingly.
And if you’re considering other asset classes, be it property or anything else, be sure you have thoroughly assessed whether you will be adequately compensated for the risks you are taking.
One of the best ways to manage investment risk is by adopting an evidence-based approach. Sticking to proven fundamentals rather than chasing returns.
