The equity premium (or equity risk premium) is the additional return that stocks are expected to deliver above the risk-free rate. It is the compensation investors demand for bearing the systematic risk of equity ownership — the possibility of permanent capital loss, deep drawdowns, and correlated losses during recessions.
Historical estimates of the realized equity premium over U.S. Treasuries range from roughly 4% to 6% annually, depending on the measurement period and whether arithmetic or geometric averaging is used. Forward-looking estimates based on valuation models tend to be lower, typically 3% to 5%.
The equity premium connects directly to the yield curve through several channels:
Discount rates: when Treasury yields rise, the equity premium narrows unless stock expected returns rise proportionally. The 2022 selloff in both stocks and bonds reflected, in part, a repricing of the risk-free rate that compressed equity valuations.
Term premium analogy: just as bond investors demand a term premium for holding duration risk, equity investors demand an equity premium for bearing equity risk. Both are compensation for systematic, non-diversifiable risk.
Allocation decisions: the equity premium relative to the risk-free rate determines the optimal equity weight for any given level of risk aversion. A shrinking equity premium implies lower optimal equity allocations.
The equity premium is the single most important parameter in long-run asset allocation. Small changes in the assumed premium compound into large differences in recommended equity weights over a multi-decade horizon.
Related Terms
Risk Aversion— The degree to which an investor prefers certainty over uncertainty, driving the tradeoff between expected return and portfolio volatility.
Term Premium— The extra yield investors demand for holding longer-maturity bonds over rolling short-term debt.
Real Yield— The inflation-adjusted yield on a bond, representing the true return to an investor after accounting for purchasing power erosion.