Why you’re mis-estimating the Equity Risk Premium #4

You haven’t factored in the likely decrease in the ERP over time

Your ERP estimate is too high. There are two related reasons for this.

Firstly, if the ERP has been trending down over time, estimating the average ERP over the period will overestimate the current ERP. Further, if the ERP continues to decrease, your estimate will be even worse over time.

Secondly, as the ERP decreases, the valuations of shares increase. Some part of the excess returns achieved from equities over the period will genuinely be due to the ERP, but another amount will be due to he decreasing level of the ERP.

Has the ERP been declining? There certainly appears to be evidence for a decline over long periods, as equity investment has become more widespread.

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Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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