Stock markets are all about taking risks. Higher the risk, higher the return. Lower the risk, lower the return. When you invest, you expect a return at least in line with the risk premium you pay to buy an asset. After all, your investment has to be worth it. Equity risk premium (ERP) is the excess return you pay between holding the risk-free return bond and the risky equity investment.
Let us start with the risk-free return bond. The most risk-free asset in the country is the government bond. It is a 10-year government bond that offers a return of about 6% annually and cannot fail.
If you do not receive your return on that, it means the country’s economy has collapsed. The actual rate of return on the bond may vary based on the market trend. Inflation is a crucial influencer to that rate of return, but that is the rate you will get as long as the government exists.
It is usually called a risk-free return. A Reserve Bank of India article released last week argues that ERP is an indicator of uncertainty and is dependent on factors like investor risk preference, macro-economic fundamentals, savings rate, market liquidity, political stability, government policies and monetary policy. Rising equity prices reflect optimism over the future profitability of companies.
Other than economic outlook, equity prices may also convey information about risk perception, the RBI article argues. “High-risk perception is associated with low equity prices and vice versa because investors demand a higher premium. They want to be compensated for higher risk against alternate safe investments in bonds, thereby driving equity prices lower,” the article states.
The Rserve Bank study further found that equity prices during 2016 and early 2020 rose due to a decline in interest rates and equity risk premium. The dramatic fall was led by uncertainty over business earnings due to the pandemic. Equity prices recovered since March 2020 on the back of hope that businesses would get back on track of profits sooner rather than later.
Economists and analysts calculate the equity risk premium using the various method. The most popular one is the dividend discount model. The technique considers the future profitability of businesses and the potential dividend. The actual process to compute involves a maze of mathematical equations.
The RBI article reveals that the average ERP between 2005-2020 was 4.7%. It peaked at 8.2% during the global financial crisis in 2008 and jumped to 6% recently in March 2020 due to the potential stress on businesses.
Now, if you take the difference between the actual return of the BSE Sensex for the period 2005-2020 and the return on 10-year government risk-free bond, it comes to 4.8%. That implies that investors have got a return in-line with the risk they took during those 15 years.
Risk-on and risk-off investing
The equity risk premium goes higher if you invest in a sectoral index fund that has only banks or technology companies. It rises further with individual stocks of companies. World over, investors tend to take risks when fixed-income investments offer a lower return. In your case, you keep money in bank fixed deposits or public provident or the National Savings Certificate.
As interest rates go down, your risk-free return is going down. So, if you were getting 8% on your PPF or fixed deposit two years ago, you are getting much less today. As your risk-free return declines, you want to maintain your interest income. So, you would look for more returns by investing in equity assets. That is when you are confident of taking on more risk.
When the ERP is lower, equity markets tend to get more support. However, if inflation rises in the economy, interest rates would start to go up. Your fixed instruments would then give you a higher return. At that point, you may switch to a risk-off mode.
You would focus on keeping your money in instruments that offer a guaranteed return that is giving a higher return than earlier. As a result, you would cut your exposure to equity assets and move money to fixed return instruments in a ‘risk-on’ investment strategy.
(The author is editor-in-chief, www.moneyminute.in)