Unpacking Equity Market Risk Premium for Investors

Key Takeaways

• Market risk premium is the extra return over the risk-free rate that investors expect from investing in the stock market.

• The metric is the investor’s compensation for assuming a higher risk level and investing in equity instead of risk-free securities.

• A negative equity risk premium occurs when the returns anticipated from stock market investments are under the risk-free rate. 

It is essential that investors understand equity risk premium (ERP), as it can help them optimize financial returns and effectively manage financial risks. In fact, the metric is a key consideration, as it is the difference between the expected return on market holdings and the risk-free rate. Here are the fundamentals of equity risk premium.

What is the Equity Risk Premium?

Market risk premium is the extra return over the risk-free rate that investors expect from investing in the stock market. It is the investor’s compensation for assuming a higher risk level and investing in equity instead of risk-free securities.

Simply put, risk premium is the price of risk for putting capital in equities as a class. The expected return on stocks is the return rate equities investors demand for such investments. It includes an equity risk premium that should go up with perceived risks.

Note that the premium is the difference between the return rate received from riskier equity investments — the S&P 500, for example — and the return of risk-free securities. The risk-free rate is a risk-free investment’s implied yield, with the 10-year U.S. Treasury note the standard proxy.

Example of Equity Risk

Equity risk is a market risk pertaining to investing in shares. It is the financial risk of holding equity in a certain investment. Depending on supply and demand, stocks’ market prices constantly fluctuate. Thus, equity risk is the risk of losing money due to a drop in the market price of shares.

The measure of risk employed in equity markets is usually a security’s price deviation over several periods.

In an example, say John, has constructed a portfolio laden with technology stocks, which have undergone substantial growth in recent years. He is optimistic about future prospects. In fact, he is so sanguine that he overlooks prospective risks of such concentration.

However, concerns about sector regulations and tech companies’ valuation escalate. This renders John’s portfolio susceptible to market risk as well as challenges specific to the industry.

Calculation of the Equity Risk Premium

The equity risk premium calculation is equal to the difference between the expected market return and risk-free rate. 

Thus:

Equity Risk Premium = Expected Market Return – Risk Free Rate

Where:

Expected Market Return —> Market Rate of Return (S&P 500)

Risk-Free Rate = 10-Year Treasury Note Yield

Note that the market return rate can be considered as the return on the index of a particular stock exchange, such as the Dow Jones Industrial Average. The risk-free rate is typically the current rate on long-term government securities.

Low and Negative Equity Risk Premium Explained

Equity risk premium is driven not just based on the overall economy, but also by market momentum and sentiments. And mood shifts can alter equity risk premiums, which can become too low if investors are overly optimistic about the future, and too high if investors are overly pessimistic. Therefore, such premiums can translate to market hope or fear.

A negative equity risk premium occurs when the returns anticipated from stock market investments are under the risk-free rate. Here, an investor would be better off with a risk-free asset than they would by taking positions in the stock market.

Determining the Risk Premium

There are multiple ways to evaluate the risk premium, considering varying investment horizons and market conditions. Such assessment is crucial, as it affects decisions in portfolio management and asset allocation. Approaches include:

— Historical Risk Premium. Investors cannot expressly glean what investors are demanding as equity risk premiums. However, they can determine what stocks, Treasury bonds, and Treasury bills have yielded historically, as that data goes back to the 1920s. This approach assumes that returns revert to historic norms over time, and that market and economic structure has not markedly changed over the estimation period.

— Historical Returns-Based Forecasts. This strategy uses the same data as above, but adds a search for time series patterns in historical returns. In other words, it includes the correlation across time in returns, which can lead to more actionable predictions. Investors who use this approach are typically bearish in today’s market. 

— The Fed Model: Earnings Yield and ERP. This is a more forward-looking approach, if the investor is open to making assumptions regarding future earnings growth and cash flows. 

Overall, the earnings to price ratio is basically the earnings that can be expected as a return on stocks. That is, if the investor assumes no earnings growth or that companies produce no excess returns. It is the basis for the popular Fed model, wherein the earnings yield is sized up against the Treasury bond rate, and the equity risk premium is the difference between them.

— Implied ERP. This strategy determines expected stock returns by evaluating the market prices of futures and options contracts, and compares expected returns to the risk-free rate. Thus, the implied ERP is the difference between the risk-free rate and expected returns.

Impact on Retirement Planning

A change in the equity risk premium can alter retirement savings strategies, as older investors are generally more averse to risk and can favor different asset classes than younger investors. 

Thus, retirees and those for whom retirement looms should carefully consider how their risk tolerance and legacy desires affect the risk premium as a strategy to fund retirement goals. 

Retirement risks include the retiree’s unknown longevity and planning horizon, market volatility, and unexpected expenses. While bonds ultimately provide a fixed return rate, and stocks can offer a greater return than bonds, such risk premium is not guaranteed.

Funding Retirement Outside the Stock Market 

For those who seek a diversified investment portfolio with less volatility than the stock market, Yieldstreet’s IRA program is an option.

One of the  leading alternative investment platforms, Yieldstreet provides the retirement account as a way to optimize potential for improved returns. That way is through the addition to their tax-favored account of private-market investments.

From real estate to art, Yieldstreet has more alternative asset classes for individual retirement accounts than anyone, with ample opportunities and easy startup. In fact, some 85% of the platform’s asset classes are available to retirement accounts.

Individuals may easily shift all or a part of a traditional, Roth, SIMPLE, or SEP IRA, or contribute new funding. Further, multiple IRAs and 401(k)s may be rolled over as well. 

Overall, tax-favored retirement accounts line up well with alternatives, with their prospects for private-market income and growth. Increasingly, those who seek to minimize risk are turning to the private market, which also could improve returns.

Alternative Investments and Portfolio Diversification

Alternatives can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

The equity risk premium is essential for assessing fundamental returns against risks, as it can guide investment decisions and require a change in savings approaches. It is a central component of market timing and stock picking. For better outcomes, it is wise to monitor this metric on an ongoing basis.