What Is the Equity Risk Premium (ERP)
The reason to buy risky stocks instead of safe government bonds is the expectation of 'earning more.' Measuring how much 'more' is the equity risk premium.
What the ERP Is
The Equity Risk Premium (ERP) is the size of the return that stocks are expected to earn (or historically earned) in excess of a risk-free asset (such as government bonds).
Put simply, it is the 'reward for taking on risk.' Because stocks carry high volatility and loss risk, investors demand correspondingly higher returns.
The ERP is used as a key input for expected-return calculations (such as the CAPM) and for valuation. A large ERP means investors demand a large reward for bearing risk.
Historical Estimates
There is no 'single correct value' for the ERP. It varies greatly depending on which period you look at, which government bond (maturity) you use, and whether you use the arithmetic or geometric mean.
According to Professor Damodaran's tallies, the historical U.S. ERP ranges from about 4.12% to 8.00% on an arithmetic-mean basis and from about 2.17% to 6.25% on a geometric-mean basis.
The very fact that the range is this wide is an important lesson. The ERP is noisy and a backward-looking estimate, so it is hard to trust blindly as a precise number.
Source: Aswath Damodaran 'Estimating Equity Risk Premiums' (U.S. arithmetic 4.12-8.00%, geometric 2.17-6.25%). The value varies greatly by period, basis, and averaging method.
Why It Matters, and What to Watch For
The ERP governs 'what expected return to assign to stocks,' so it greatly affects retirement planning and asset-allocation assumptions. Assuming a high ERP makes you view the future optimistically; assuming a low one makes you view it conservatively.
Things to watch for:
1. The ERP is not a guaranteed future return. There is no assurance that past premiums will repeat in the future. 2. Over short periods, stocks often underperform government bonds (there are stretches of negative premium). 3. The value can differ by more than twofold depending on the estimation method, so relying on a single number is risky.
It is best to use the ERP as a lens for understanding that 'risk comes with a reward, but that reward is not always, every year, realized.'
よくある質問
Q. Is the ERP always positive?
On a long-term average it tends to be positive, but over certain periods stocks lag government bonds and the premium becomes effectively negative. It does not mean 'stocks always win.'
Q. Is there one precise value for the ERP?
No. Depending on the period, choice of risk-free asset, and averaging method, even the U.S. figure ranges widely from the 2% range to 8%. That is why it should be understood as a range.
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