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.