No investor in shares could possibly say now that they don’t understand that shares can be a risky asset to hold. But from that very risk comes one of the best weapons in the investor’s armoury, the equity risk premium (ERP).

The ERP holds that over the long term, shares will outperform the risk-free cash rate and government bonds. Investors demand this premium to invest in the more risky asset of equities.

Over the period 1900-2007, according to the ABN AMRO/LBS Global Investment Returns Yearbook 2008, the Australian stockmarket generated the highest ERP in the world – a 6.6 per cent gap in the annualised returns between shares and bonds. This compares to 6.5 per cent for the USA, 5.5 per cent for the UK and 5.3 per cent for the world (excluding the USA).

Arun Abey, co-founder of ipac Securities and head of strategy for AXA Asia-Pacific, calls the ERP “the Investment Prize.” Abey describes it as “one of a handful of resilient forces in the world of investing”: capturing it as part of your wealth creation “can make the difference between a lifestyle that meets your expectations, now and in the future, and just getting by.” But, he is quick to add, the ERP should not be considered “an article of faith.”

“The ERP is not a God-given right – there are circumstances when it can actually disappear for long periods. The ERP will always exist in a market-based economy, but it will be volatile,” says Abey.

The basis for the ERP, he says, is that companies borrow from banks because they believe they can make a higher return than from cash. “Sometimes companies get that equation wrong, and they go bust. The companies that survive are the ones that can repay the bank. The ERP says that a long-term investment in equities will provide a higher return than the return from cash. If that were not the case, companies could not afford to borrow from banks.”

The essence of capturing the ERP, says Abey, is to “buy good-quality companies, don’t pay too much and spread your risk by diversifying.” Because the ERP refers to the return generated by shares as an asset class, a simple way to pick it up while gaining good diversification at the same time is to buy an index fund or exchange-traded fund (ETF) that tracks the performance of a stockmarket index. In this way you can simply and cheaply achieve effective underlying exposure to hundreds of stocks, in either your domestic or international equities allocation.

But there is one major drawback with the ERP: it is not valid for any and all time periods. Clearly, someone buying shares in October 2007 has not enjoyed anything close to a premium.

“You can easily have a situation, as we’re seeing over the last year or so, where the return on equities is actually less than the return on cash. That is part of the economic cycle: when the economy turns downward, companies collectively aren’t able to make enough profit vis-à-vis the cash return – and some go bust. But over the full economic cycle, it simply has to be the case that the return on equities has to be greater than the return on the bank interest rate – because if it weren’t, the banks themselves wouldn’t survive, because the whole banking system wouldn’t survive,” says Abey.

The other major drawback of the ERP is the risk that – as with all historic performance – Australia’s standout ERP will not be repeated.

“Unfortunately, this isn’t like cricket, or rugby, where you can always be the best,” says David Stuart, head of the dynamic asset allocation team at Mercer Investment Consulting. “Australia is the best-performing equity market in the world in terms of the equity risk premium, but we expect Australia to come back to the pack.

“While the last 100 years as a whole was a period of incredibly strong growth for Australian equity market, some of those years had some very good stuff in them. If you look at the last ten years, Australian equities only generated an ERP of about 1.5 per cent a year. Going forward, relative to long-run history, we expect the ERP for Australian investors to be a bit better than that, but lower than the long-run figure.”

At present, assuming a cash rate of 5.5-6 per cent over the next, Stuart says Mercer expects an ERP of 3.5 per cent over the next one to three years. “That 3.5 per cent takes no account of current valuation. From here, over the course of the next one to three years – what we consider to be medium-term – the prevailing low valuation of equities means that an investor could reasonably expect more than that 3.5 per cent.”

Tim Farrelly, who runs specialist asset allocation consulting firm Farrelly’s, says investors have to be clear on the limitations of the ERP concept. “The whole concept of an equity risk premium as something you get by right of buying equities is complete nonsense. You get the equity risk premium when you buy equities when they’re cheap; and you don’t get it when you buy equities when they’re expensive. It’s as simple as that. Equities as a fundamental vehicle will outperform if you buy them at the right price – if you don’t, they won’t.”

Farrelly says investors only have to look at the relative performance of US equities versus US bonds. “What’s absolutely fascinating is that if you’d bought US bonds at any time since 1980, you could have more money than the equivalent investment in US equities. That’s stunning: 29 years of what have been predominantly bull markets, yet where we are today, any single month since 1980, you would have done better buying bonds than equities. That tells you all you need to know about the concept of an equity risk premium.”

Stuart says an investor needs to go to a 20-year horizon before the risk of the real return from equities being negative becomes negligible. “20 years is a long time, but that points to how we should actually view the equity risk premium – as tying in with the use of equities as a long-term, liability-matching kind of investment – in place to match retirement timeframes. But over anything shorter than 20 years, the ‘risk’ part comes into play,” he says.

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