The attached note looks at the equity risk premium – what is it and is it enough?

The key points are as follows:

– The equity risk premium is the excess return that shares provide over a ‘risk free’ asset like government bonds.
– It is perceived that in order to compensate for their greater short-term volatility and risk of loss, shares should return between 5% and 7% pa more than bonds over the long term. Mainly because this is what their excess return has been over much of the post-war period. However, this likely exaggerates the required excess return for shares.
– Due to the recent bear market, shares have struggled when compared to bonds over the last decade. This should not be interpreted as meaning that shares are a dud investment. In fact, thanks to now low government bond yields and higher dividends yields on shares, shares should provide a good risk premium over bonds throughout the decade ahead.

While shares are vulnerable to a correction after their sharp gains from March, their attractive prospective risk premium compared to bonds suggests that any short-term pullback in shares will simply be a correction in a still rising trend.

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