Perspectives on the Equity Risk Premium

The equity risk premium has commanded the attention of professional economists and investment practitioners for decades. It is critical in financial economics; it determines asset allocations, projections of retirement and endowment wealth, and the cost of capital. Economists are still searching for a simple model that justifies the premium in face of the much lower volatility of aggregate economic data. Although the future equity risk premium is apt to be lower than it has been historically, U.S. equity returns of 2–3 percent over bonds will still amply reward those who will tolerate the short-term risk of stocks. The equity risk premium—the difference between the expected return on stocks and the return on risk-free assets—is one of the most important numbers in finance. If geometric average returns are used and the premium is measured against the return on long-term government bonds, the premium in the U.S. markets has risen from 3.31 percent for 1802–1926 to 4.53 percent since 1926. The equity premium, which is only slightly lower in other countries than in the United States, is significantly higher than can be explained by economic models using reasonable levels of risk aversion.Changes in the standard economic model have yielded some promising results. The size of the equity premium can be shown to be related to habit formation in consumption, the riskiness of labor income, and a condition called “loss aversion” that is emphasized in behavioral finance. Fat-tailed risks and long-term cycles that are not represented by the standard normal distribution can also lead to an increase in the equity premium.In the future, because of sharply lower transaction costs and the ability of investors to hold fully diversified portfolios, stock prices should rise relative to fundamentals and reduce the future real returns from equities by about 100 bps, to 5.5–6.0 percent. If future real bond yields return to their long-run historical average of 3.0–3.5 percent, the equity risk premium will settle at 2–3 percent, a level that is consistent with many money managers' expectations. If future real bond returns remain in the 1.5–2.0 percent range that they have fallen to in recent years, the equity risk premium is likely to return to the 4.5 percent level achieved since 1926.The search for the right model of the equity risk premium has yielded insights that can guide practitioners in structuring their clients' portfolios. First, habit formation implies that an investor's short-term and long-term attitudes toward risk may differ. Second, an investor's labor income may cause significant differences in asset allocation. Third, the idea that risk aversion becomes extremely high at low levels of consumption has given rise to “liability investing,” in which investors, especially those approaching retirement, fund what they deem absolute minimum expenditures with risk-free assets and allocate the rest according to the usual risk and return trade-offs.