Equity Risk Premium (ERP) has been extensively written by many people and yet it is often misunderstood. Recently Howard Marks, Chairman of Oak Tree Capital wrote how much misinformation is there about ERP1. Howard Marks was recently named as Guru of Wall Street by Barrons.
In a nutshell, only historical ERP can be measured and seen. Just because the long run historical ERP was 4%-5% does not mean that ERP is 4%-5% or will be or that is what investors will get even though they may wish for. One can see returns of Stock market year over year; the returns are different every year and in some of the years it were negative. Yet if one goes back to look at the predictions at the beginning of the year, the ERP for next one-two year is always in the range of recent returns. This 4-5% has been computed over 85 year of data in US. Often, how long this average has been computed is often forgotten. Ibbotson has done extensive research on this average computation2.
The statement that ERP is rising or falling is over generalization about ERP. As mentioned in numerous blogs before, the most important thing to determine the value of the asset is to determine the expected cash flows from the asset. If assets have returned excess return over its ability to generate returns, then its future returns from holding that will be less.
Jeremy Grantham of GMO has mentioned number of times; Investors often extrapolate the past into the future. He is a big proponent of mean reversion of returns. In reality, many investors never think about reversion to mean. As returns from equity market increase in relation to risk free rate; investors assume that returns will continue in the future. This is where investors make mistakes, even though all mutual fund documents clearly says past is not an indicator of future, investors continue to believe expect that ERP will be similar to what it was in the past. Investors ignore that warning as smokers ignore the warning about smoking.