The Equity Risk Premium - What It Is And How You Use It

The equity risk premium is a basic concept related to investing in stocks.

Rolling the dice is far more risky than using the equity risk premium.
Unlike gambling, the equity risk premium says you should be rewarded by taking a chance. Colin Anderson/Getty Images

The phrase 'equity risk premium' is a financial term that refers to the excess return, above and beyond the risk-free rate of return, that you would expect to earn from investing in stocks. The risk-free rate is measured by T-bills, or long-term government bonds, as this type of investment is considered by academics to be risk-free (in that the U.S. Government is not expected to default on its loans).

An equity investment is expected to earn an excess return over the risk-free rate to compensate an investor for taking on the risk of uncertainty. Or in other words, if you are going to take a risk, you expect to be rewarded for it – otherwise, why take the risk? According to the paper History and The Equity Risk Premium, the equity risk premium is “one of the most important economic topics in modern finance.”

How is the Equity Risk Premium Measured?

Only historical equity risk premiums can be calculated precisely. For example, if a long-term government bond (or risk-free investment) had a return of 3% and a stock had a return of 11%, the equity risk premium was 8%. When looking at the equity return, capital gains and dividends are included.

You can estimate a future expected equity risk premium by using a projected rate of return for a stock investment. These estimates are used by many investment managers in an attempt to model out and project future returns.

If a stock is not expected to deliver a return much higher than a much safer choice, it may not be an investment worth making. The CFA Institute has a research paper called The Equity Risk Premium that dives into additional detail on methods of calculation.

Using the Equity Risk Premium

The equity risk premium help you gauge how ‘risky’ an investment is relative to the risk-free rate.

When buying an equity with a higher risk premium, you expect that the return will be higher. There is no free lunch, so you must expect more risk with an investment that has a higher potential return. If you are willing to take on the risk and you don't need to cash in your investment if the market is down, then you may be rewarded in the long run with a higher rate of return than what you would have received by using other safer investment choices. 

If you don't want risk, you avoid the equity risk premium by avoiding stock investments altogether. However, if you invest only in safe investments, you take the risk that inflation will outpace the returns you earn.

For Retirees

Equity risk premiums are more of a concern for those in retirement (or near retirement) because of the shorter time horizon you have. If the equity markets go down 50% in value the year before you retire, and you have a large portion of your investments in equities, this will affect the total amount you can withdraw during your retirement years.

As you take withdrawals from your portfolio, if you need to sell equities when the market is down (volatility goes hand in hand with equity risk premium), then you may be forced to sell at market lows.

Equity risk must be carefully managed through proper asset allocation as you near retirement, and once you are retired.

My Experience with the Equity Risk Premium

Back in 1999, before I was a financial advisor, with all the money I had saved (which wasn’t a lot, but all I had), and without knowing anything about markets, I went to a broker and told them I wanted to invest. Given my age, the broker said, 100% equities would be my “ideal” portfolio, but didn’t explain that I needed to actually stay invested for the long-term (more than 10 years). Needless to say, over the next three years, the equity markets did not do so well.

This is when I decided to sell everything, a natural reaction, but not a very good one. Lessons learned:

  1. Depending on the time you start and end your investment, you may not be compensated for the equity risk you take… know your time frame and stick to it.
  2. Selling at the bottom means you have no chance to recover the losses you have already suffered.

I wish I had done a bit more research before I started my investing endeavor and stayed invested over my anticipated investment time horizon (which would have been much longer than three years).

Instead of viewing this as a total loss, I viewed this as a challenge to figure out and learn as much as I could about how investing really works. This eventually led to my career as a fee-only financial advisor.