Abstract

The equity risk premium arises from the link between equities as an asset, and corporate profitability and growth. In this paper, we review the concept and measurement of the equity risk premium against a background of recent practitioner debate concerning the suitability of equities for long-term institutional investors. We consider the competing versions of the equity risk premium that are quoted by academics and practitioners, highlight issues of estimation and consider how they can be addressed robustly. We conclude that equities as an asset class offer a robust return premium over long-dated bonds of the order of 2.5% to 3% per annum globally. This is an estimate which adjusts for the experienced changes in market valuations, and is based on detailed empirical analysis of many equity markets over more than 100 years. Diversified exposure to a basket of global equity markets is most likely to deliver this estimated risk premium over time, rather than a concentrated single-country portfolio. Against the same background, we also revisit the debate over time-diversification i.e. the term-structure of the volatility of asset classes with investment horizon. We conclude that the mean-reversion in equity market valuations drives that of equity returns and this mean-reversion directly ensures that the volatility of equities decreases with longer investor time horizons. Hence, in practice, the 'shortfall' risk of equities is less serious than often thought by investors and especially compared with other assets such as bonds when investing for the long-term i.e. over full business or economic cycles.

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