What is the Equity Premium and Why It’s Important

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Knowing the allocations and return differences between stocks and bonds is essential for investors with large portfolios who want maximum diversification.

This is the basis, but how do you measure the differences?

It’s done by measuring the equity risk premium.  This measures the long-term market relationship between the historical expected return difference between stocks and bonds.  This difference is one measure that helps determine the stock-bond asset allocation in the portfolio.

The equity risk premium is the difference between the long-term expected returns between stocks and bonds.  It is a crucial assumption used by investors–such as pension and endowment funds, foundations, and individual investors, including 401(k) participants and very high net-worth individuals – when deciding how much to invest in stocks and bonds to meet them to meet future needs.

The traditional equity risk premium has been 4% in the past. This premium was in line with post-war capital market history and within the range shown as reasonable in academic studies. The recommendation to use a 3% risk premium relied on further research into the long-run behavior of corporate earnings growth, dividend yields, and intermediate Treasury bond returns.

This measure forecasts future returns for large portfolios, such as pension funds.  However, when the premium is reduced, investors will have to take more risk for the same return in the future, or they will have to expect decreasing returns.

What This Means?

While seemingly esoteric, the change in calculating the equity risk premium has broad implications. Take a portfolio that is 60% equities and 40% debt. A 1% reduction translates into a 60 basis point, or 0.6%, reduction in expected return.

While a 0. 6% reduction in an investor’s expected return on an investment may not seem exciting, it has significant ramifications over the long term.

The reduction in expected returns affects corporate pension plans’ accounting for their plan. The 1% equity premium reduction implies the fund should reduce its expected long-term return on assets (ELTRA). A formal reduction in the ELTRA would raise pension expenses immediately.

If a fund does not change its assumption and returns are consistently less than expected, it can expect an increased frequency of amortized losses in the future.  For individuals who accept the idea of a lower future expected return, investment theory indicates that when investors think an asset will not return what it has in the past, that asset becomes less attractive.

When this occurs, investors can develop a higher appetite for other investment opportunities that offer higher returns, such as hedge funds, private equity, and real estate.  While these investments provide higher expected returns at higher risk levels, their relative attractiveness to lower-returning assets, such as stocks, becomes stronger as the equity premium is reduced.

Does this mean US investors are increasingly willing to hold more risky assets, such as stocks, as opposed to a few generations ago, when bonds were more common?  What would account for this change?

Modern capital markets better have increased ways to diversify risk, such as investing in low-cost mutual funds, so investors can collectively take more equity risk.  Since retail investors have become more invested in equities of all types, individual stocks, mutual funds, and ETFs, they have increased overall equity valuations.  This has worked to reduce the required return for holding equities based on traditional stock-bond relationships.

 

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