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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