1.3 The equity risk premium

For details of companies listed on the London Stock Exchange, go to www.londonstockexchange.com/ statistics/ home/ statistics.htm [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)] . For details on the different FTSE indices, go to www.jrank.org/ finance/ pages/ 2031/ FTSE-Indexes.html.

The overall or average rate of return on shares or equities can be measured by the rate of return on a stock market index. This is a number designed to reflect the returns (dividends plus capital gains or losses) of shares that are representative of the stock market as a whole. It is the rate of return you would obtain if you invested in every company share traded in the market, weighted for each company’s relative size. In practice, there are a number of stock market indices available for each stock market. Some indices are designed to reflect only the performance of the largest companies, but an index designed to reflect the market as a whole is needed here. In the UK, this is the FTSE-All Share Index that actually only covers around 700 shares out of the 2,700 or so listed, but these shares account for 98% of total market value and 90% of turnover by value.

Equities on average have higher returns than bonds because of their greater risk, with risk usually measured by the standard deviation of the returns. This has been demonstrated by Dimson et al. (2002) using historical returns during the period 1900–2000. They showed that, during this period, UK equities achieved mean annual nominal returns of 12.1% compared with 6.1% for UK gilts. Their work also demonstrated how three-month UK Treasury bills yielded, on average, an annual 5.1% in nominal terms over the same period. Therefore, in the past, companies raising equity finance have offered higher returns to their shareholders than what was available on risk-free assets in order to compensate for the additional risk of equities.

This difference between the return on equity measured by the return on a stock market index and the risk-free rate is known as the equity risk premium or market premium (The term ‘equity risk premium’ is used here but you may see the term ‘market premium’ elsewhere). This premium is usually calculated as the simple difference between the two. Based on the historical data on nominal returns for the period 1900–2000 (Dimson et al., 2002) and using Treasury bills as the risk-free investment, the equity risk premium was 12.1% – 5.1% = 7%. If, instead, long-term government bonds were used as the risk-free benchmark, the market premium was somewhat lower: 12.1% – 6.1% = 6%. This implies that, on average, over the last 100 years or so, equity investors have earned between 6% and 7% each year as a premium for taking on the risk of buying shares rather than investing in risk-free government bonds. Note the use of the phrase ‘on average’: in any one year or decade, returns could be much higher or lower than expected and certainly might differ substantially from the long-run average market premium achieved in the 20th century.