Mis-estimating the Equity Risk Premium

The Equity Risk Premium (ERP) is the expected excess return priced into equities as reward for bearing risk. Equities are expected to provide greater returns because they are riskier than, say, government bonds.

The historical ERP experienced (and prospectively estimated by some) is higher than many theoretical assessments of what it should be based on the average investor’s risk aversion. There are many problems with estimating both the ERP itself and the risk aversion of an average investor. This discrepancy has been known as the Equity Risk Premium Puzzle since the 1980s when it was first popularised.

The ERP is an important assumption in many valuations and as such, getting it right is also important.

This post serves as an introduction into a series of posts on mis-estimating the ERP.  It needs a series of posts because there are so many different mistakes than can be made.

For the record, my own assessment (based on meta research and drawing heavily from the fantastic book Triumph of the Optimists – 101 years of Global Investment Returns that considers the problem very rigorously) is between 3% and 5%.

I view 4% as a single best point estimate, but admittedly tend to use 5% in some of my own valuations when I want to be prudent. Importantly though, using a higher ERP isn’t always prudent, but more on that in a much later post in the series.

Reason #1 – You’re basing your estimates on US history alone

Reason #2 – You’ve used too short a period

Reason #3 – You’ve used the ‘wrong’ risk free rate

Reason #4 – You haven’t factored in the likely decrease in the ERP over time

Reason #5 – You’ve been swayed by others’ use of high ERP estimates

Reason #6 – You haven’t checked your result with prospective estimates implied by the market