Investing always comes with a risk factor. Different investment options have different risk factors. The image has the risk and returns of a few instruments.
You can see the returns from equity are higher than returns from Debt Mutual Funds. Returns from bonds are lower compared to Debt Mutual funds. The excess return compensates investors for taking on higher risk. An investor investing in more risky instrument has the potential to earn more than the investor who invests in a low-risk instrument. The excess return earned by investing in the stock market or a particular stock is called equity risk premium. It is the compensation paid to the investor who takes upon himself the higher risk of the equity market fluctuations.
A simplistic way to calculate is to compare the equity stock returns and a zero risk investment like Government Bonds. The difference between them is equity risk premium.
A more comprehensive way to calculate is to use the Capital Asset Pricing Model (CAPM). It is calculated as -
Rs = Rb + βs (Rm - Rb)
Rs - expected return on investment in a stock.
Rb - risk-free rate of return, which can be the return on bonds
βs - volatility of the stock
Rm - expected return of market
Of course, there is probability of loss in every investment. If that risk is to be considered, a calculated percentage can be deducted from the returns on the Government bonds.
Why Use Equity Risk Premium?
It can be used to predict how a stock will perform compared to zero risk or low risk investment options. It is assumed that the stock, market and bonds will perform as they have performed in the past which may or may not be true. Moreover other factors such as net profit margin, revenue and the earning per share etc. also play a role in the price of a stock. So the equity risk premium should be considered factoring in these parameters as well.
The equity risk premium of the overall market is different from that of a particular stock.
It is a good metric to choose stocks. Stocks with a higher equity risk premium are more risky. If the yields on bonds go higher, then returns from stocks should be more to compensate for the risk. You can select stocks on the basis of the equity risk premium and match it to your risk tolerance levels and risk capacity levels. Volatility plays an important role too. If there are many uncertain events or volatile market conditions, volatility will be higher which will affect β. For example, in 2019, we have the elections. There are pressures on the rupee and crude oil supplies. There is a demand slowdown in China. So, volatility can be higher; leading to higher risk.
It is therefore important to research and analyse stocks and invest based on based on fundamentals.
Returns from equity are not constant. They can fluctuate and sometimes be less than returns on bonds. Therefore there is a higher chance for the long-term investor to earn more in equity than on bonds as compared to short-term investors or traders.