Equity Risk Premium = 9%?
Iāve been a little obsessed with learning about the equity risk premium lately.
I think it gives us a much better framework for thinking about what a reasonable long-term return actually is, rather than just looking backwards at what stocks happened to return.
Aswath Damodaran, professor of finance at NYU Stern and someone the media has nicknamed the āDean of Valuation,ā publishes an ongoing estimate of the implied equity risk premium.
The ERP is basically the extra return investors demand to own stocks instead of a risk-free asset. As of August 1, Damodaranās implied ERP for the U.S. was 4.28%, with a U.S. Treasury rate of 4.74% used as the risk-free rate. Very roughly, that gives you something around a 9% expected nominal return for the market as a starting point.
That does NOT mean stocks are going to return 9% next year. Damodaran himself makes that distinction pretty clearly. He says you cannot predict what markets will do over the next year, but when looking over the next five to ten years, āthere is predictive power.ā
He also says the equity risk premium āunderlies almost everything we do as investors.ā
The more I learn about it, the more intuitive that becomes.
For a Canadian analogy, imagine I can buy Government of Canada T-bills and earn a relatively safe return. If Iām going to leave that behind and own stocks, where the outcome is much less certain, I need some additional expected return to compensate me.
But there is also a counterbalancing force that I think is really important: competition.
Public stock markets are incredibly open and liquid. There are millions of investors, institutions, pension funds, hedge funds and algorithms constantly comparing opportunities and looking for attractive expected returns.
Imagine relatively safe assets are yielding 4% or 5%, but stocks somehow offer a 20% long-term expected return without requiring some extraordinary ingredient to produce it. That would be an insanely attractive deal.
People would buy stocks. Prices would rise. And paying a higher price today lowers the return you can expect going forward. Capital keeps flowing toward the opportunity until the expected reward becomes more reasonably balanced with what investors have to give up or take on to earn it.
None of this requires markets to be perfectly efficient. Damodaran himself says markets āovershootā and āundershoot.ā Mispricings happen.
But there is a big difference between saying markets can be wrong and saying an enormous, obvious, persistent opportunity can just sit there indefinitely in one of the most competitive markets in the world.
This is where I think discussions about āsustainableā returns sometimes get misunderstood.
A 20% total return can obviously happen. It can happen next year. It can happen several years in a row. Realized returns are noisy.
The question is whether 20% is a reasonable long-term expected return to build your assumptions around.
If you expect to sustainably earn 15%, 20% or 25% over very long periods, there has to be some kind of secret sauce explaining why your expected return is so much higher than what the broader market is pricing.
Maybe itās leverage applied to a positive expected risk premium. Maybe you have exposure to some compensated source of risk. Maybe itās genuine skill, an informational or structural advantage, or a persistent market inefficiency.
But simply taking āmore riskā isnāt enough of an explanation. You can take all kinds of risk without increasing expected value.
And even if the secret sauce is real, there is another question: why should it persist?
If other investors can identify it, access it and scale it, capital should eventually flow toward the same opportunity. Prices adjust and at least some of that excess expected return gets competed away.
So extraordinary returns are not impossible.
But extraordinary long-term expected returns require an extraordinary explanation, and even a genuine edge may not survive forever.
