Equity Premium
The equity premium is the excess return that investors expect to earn from holding equities rather than a risk-free asset, such as government bills. It is the compensation that investors require for bearing the additional risk of owning shares, and it is one of the most studied quantities in finance. The historical average excess return of equities over bills has been large in many countries, and the difficulty of explaining its size within standard models is known as the equity premium puzzle.
Definition and measurement
The equity premium is usually defined as the difference between the expected return on a broad market index and the return on a short-term government security. Ex ante measures use expectations or model-based forecasts, while ex post measures use realised returns. Realised excess returns have averaged several percentage points per year over long periods in major markets, implying that equities have substantially outperformed bills, but with much greater volatility.
Direct measurement of the expected premium is difficult because expectations are unobservable. Analysts infer expected returns from dividend yields, earnings yields, and valuation ratios, or from survey forecasts, and each method has limitations. Realised returns provide an estimate of the average premium over a historical period, but they are noisy, and a long sample may be needed before the average is estimated with precision.
Explanations
Several explanations have been proposed for the size of the equity premium. Risk-based explanations hold that equities are risky and that investors require a large reward for bearing that risk. Because consumption tends to be low in bad states of the world, when equity returns are also low, equities are especially unattractive, and the required premium is high. However, to generate the observed premium with plausible risk aversion, models require a degree of risk aversion that appears implausibly high, which is the essence of the puzzle.
Other explanations appeal to rare disasters, to habit formation, and to long-run risk. If investors attach significant probability to catastrophic outcomes, they will demand a large premium even if such outcomes are rare. Habit formation, in which investors care about consumption relative to a slowly moving reference level, can amplify risk aversion in bad times. Long-run risk models emphasise persistent, predictable components of consumption growth that make equities especially risky over long horizons.
Behavioural and market-based explanations
Behavioural explanations emphasise departures from full rationality. Myopic loss aversion, in which investors evaluate their portfolios frequently and dislike losses more than they like gains, can lead to a large required premium. Overconfidence and extrapolative expectations can cause prices to deviate from fundamentals and returns to be volatile. These accounts are supported by evidence from laboratory experiments and from investor behaviour, although their quantitative importance remains debated.
Market-based explanations focus on frictions and institutional factors. Limited participation means that only a subset of households holds equities, so the premium reflects the risk borne by those households rather than by the population as a whole. Borrowing constraints, liquidity needs, and the tax treatment of different assets can also affect the premium. Some analyses argue that survivorship bias and the special history of the United States market have led to an overstatement of the historical premium.
Implications
The equity premium matters for asset allocation, for the cost of capital, and for policy. A large premium implies a high cost of equity for firms, which affects investment and valuation. It influences the portfolio choices of households and pension funds, and it underlies the common advice to allocate a substantial share of long-horizon portfolios to equities. It also affects the valuation of public policies whose benefits and costs accrue in different states of the world.
For financial stability, the premium and its variability matter because they influence asset prices and risk-taking. Periods of low premia may signal complacency, while periods of high premia may reflect fear and illiquidity. Understanding why the premium is as large as it is, and how it varies over time, remains an active area of research, with implications for how investors and policymakers should behave.
Time variation and predictability
The equity premium is not constant. It varies over time, rising in periods of stress and falling when optimism prevails. Measures based on valuation ratios, such as the cyclically adjusted price-earnings ratio, suggest that the expected premium is high when prices are low relative to earnings and low when they are high. This predictability, while statistically modest, has implications for asset allocation and for the design of long-horizon portfolios.
The time variation also raises questions about the stability of the historical average. If the premium varies with conditions, then the average over a long sample is a mixture of high and low periods, and the applicability of the historical average to the future is uncertain. Some analysts argue that the premium going forward will be lower than in the past, because valuations are higher and because the exceptional performance of some markets may not be repeated.
International evidence
International evidence on the equity premium is mixed. Some markets have delivered large excess returns over long periods, while others have not, and the average across countries is lower than that of the most successful market. Survivorship bias, the fact that the historical record is drawn from markets that survived, may overstate the premium. Emerging markets show higher average returns with much greater volatility, reflecting their riskier environments.
The international evidence also shows that the premium varies with institutional factors, including the quality of investor protection, the depth of markets, and the availability of alternative assets. Countries with stronger institutions tend to have lower required returns, because investors face less risk of expropriation and fraud. These findings link the equity premium to the broader institutional environment and to the development of financial markets.
Implications for saving and retirement
The size of the equity premium has practical implications for saving and retirement planning. A high premium implies that a given amount of saving will grow more rapidly if invested in equities, reducing the required contribution to achieve a target retirement income. A low premium implies the opposite, requiring higher saving or longer working lives. Estimates of the premium therefore influence the advice given to savers and the assumptions used in pension fund valuations.
The uncertainty about the premium complicates planning. Because future returns are unknown and the premium varies, savers face risk, and the appropriate response is diversification and prudent assumptions about returns. Regulators and pension supervisors encourage realistic assumptions and stress testing, to avoid the overpromising that can lead to shortfalls. The debate about the size of the equity premium is thus not only academic but also of direct practical importance.