The Equity Risk Premium

Sep 2014 //
Economics
Behavioral Finance
Optimism/Pessimism

Economic and investment theories (and common sense) tell us that in order to accept greater risks, investors demand greater returns.  Although we could make the case that over the very long term the risks faced by investors don’t vary that greatly, over the shorter term they do—at least, the perception of risk can vary greatly.  If we want to test the theorized relationship between expected risk and return, we should search for historical periods when investment risks were perceived to be high (or low) and then look to see what returns were thereafter.  The environment of the 2007–09 financial crisis and its aftermath would seem to be tailor-made for this purpose.  After all, in the depths of that bear market investors  were as worried as I have seen them in my lifetime.  Economic and investment theory would say that stock returns from 2009 forward should have been higher than normal—and that’s exactly what they were.  From the market bottom through August of 2014, the S&P 500 averaged an annualized return of over 20%, which is far higher than more normal 10% annual returns.  Indeed, you could correctly say that the decline in stock prices, which was far greater than the decline in GDP, was simply the mechanism by which the stock market priced itself for high future returns.  Put differently, low initial stock prices create the potential for large future returns, which is what investors demand when they are fearful.  The amount by which future stock returns are expected to exceed the returns on very stable investments is known as the “equity risk premium.”  Obviously, it pays to invest when the equity risk premium is high, and this means that it pays to invest when other investors are worried.