Previous articles in this series have encompassed some of the key themes with regard to the Equity Risk Premium ERP. In this instalment I propose to examine some of these using UK data from Thomson Datastream and other sources. We will also consider how the premium is calculated, using arithmetic or geometric means, and also give some thought to what is a risk-free asset.

To begin, we will examine the sources of the data before digging into the Equity Risk Premium historical data. Dimson et al explained that it was fundamental to use total returns when measuring long-term performance.

This means we include dividends when looking at the equity returns as p. This has been important in my consideration of the data to use in this section of the paper and accordingly, my calculations on the following pages are based of the FTSE All Share Index for equities and the FTSE Actuaries UK Conventional Gilts.

Click images to enlarge. Conventional Gilts Index Constituents Source: With regard to both indices, only total returns are being considered, unless otherwise stated and this data will be the source of the following ERP calculations. Since the financial crisis of , the rates on risk free assets have reached exceptionally low levels.

In the UK, the Quantitative Easing policy has pushed down yields on Gilts, often making them negative on an inflation-adjusted basis. What are the implications for ERP? When we look at our data from the FTSE All Share for , gilts outperformed equities on a real monthly returns basis on seven occasions, as can be seen in Figure 2.

It is clear to see that the third quarter was poor for equities, reflecting the impact of the July EU Summit and the fears of sovereign default and contagion.

On a real annual total return basis for , equities were Certainly the yields would be suppressed but this is more than balanced by the price appreciation which forms the basis of the high return. Given these recent developments, it makes us more aware that it is difficult to talk about, and calculate an Equity Risk Premium historical data.

Arnott raises this point so it is imperative that we look at the risk premium over a longer period. Before doing so, we must examine the Equity Risk Premium over the period that concerns us, to Figure 3 illustrates this:. These Equity Risk Premium historical data points have been calculated after taking inflation into account and are based on annual returns.

It is worth noting that over this time period the distribution is not symmetrical, and could not be described as a normal distribution. This contrasts with Dimson et al whose year-by-year US data was roughly symmetrical, given their longer time period. The average premium is 3. This perhaps does not seem to be a great reward for the extra risk that equities expect of investors.

Equity Risk Premium Historical Data: to | See It Market

We can identify some of these in the data. There are some critical moments which impact the annualised returns, such as October and August The ERP for and were Over this period they have a mean of 9. The chart starts from as we are computing annual returns and our data commences in Real Annual Returns to Appendix 2. Following on from the data in Figure 5 we may calculate Equity Risk Premium historical data: Indeed, if we look at the rolling ten year ERP, we can see that the risk premium is trending downwards, as is made clear in Figure 7, providing a contrast to Figure 6.

As we can see, the rolling ten-year mean Equity Risk Premium is 0. We would expect this value to be higher than the annual ERP but we are constrained by the time period of our data. It is also worth noting though how even these returns have been impacted by the events of to and the financial crisis, emphasising the importance of timing in generating reasonable returns.

An important aspect of the ERP is what exactly is it being measured against? We will look at the gilt data we have available and thereafter compare that to other measurements which may be considered risk-free.

From the data we have available for this section we can compare the ERP using gilts of three distinct durations: As a starting point, it is worthwhile to compare the returns on these gilts against equities on the FTSE All Share:. One of the first things we notice is that the longer duration gilts have outperformed equities on a number of occasions in our time period.

Also, and as expected in declining markets, equities perform worse than gilts. This evidence makes it clear that choosing the benchmark risk free rate making the assumption that gilts are risk-free is crucial, and again highlights the importance of looking at as long a timeframe as possible. From this, we can now calculate the Equity Risk Premium historical data and as with our previous examples, the values have been calculated using annual geometric returns and are on a total return basis.

What is the historical market risk premium? | Investopedia

Figure 9 illustrates this:. ERP and Bonds of Different Duration Appendix 4. It is noticeable that there is a close correlation between the three different lengths of gilts we are studying. The correlation between up to five years and five to fifteen years is 0. These correlations are as would be expected, with the adjacent time periods being more closely correlated. It is interesting to note, and as we have seen earlier, that the Equity Risk Premium is extremely volatile and is often negative.

The periods which are most noticeable above all follow major crises as previously examined: Given this information, it is of value to illustrate the relative performance of the different duration bonds and the ERP:.

The correlation between these shorter term gilts and equity returns is 0. This is as you would expect as there is the opportunity for greater volatility to have a greater impact over a shorter time period.

Market risk premium: Required, historical and expected

For the next bond duration, five to fifteen years, the correlation is 0. This is interesting as the correlation is increasing and perhaps the most noticeable feature is the increased downside volatility following the crisis. This is also reflected in the premium against gilts of over fifteen years.

The principal difference is that we do not have an upside spike in the early years of this data. The overall pattern is very similar though and the total return correlation between these gilts and equities is 0. This is in line with Dimson et al , p. The higher correlation that they found would be a product of looking at data over a one hundred and one year period.

In the following table we can see a summary of the Equity Risk Premium historical data against gilts of different duration:. Risk Premia relative to Gilts of Differing Duration. For our period it also illustrates that seeking a reasonable premium for risk may involve staying in the market for a prolonged period.

As we have seen though, this is still no guarantee of success if you have invested for twenty-five years or more and you have a repeat of, for example, or In the tables above, the Equity Risk Premium historical data covers the period to and it is noticeable the difference between the annual and ten year premia, reinforcing the point made above.

As we have noted before, and as mentioned by Dimson et al , the geometric and arithmetic means are similar, reflecting a fairly stable environment. Dimson et al cite the Barclays Capital and CSFB research which calculated the UK ERP, relative to bills, to be 6. Dimson and his co-authors found this to be 4. It is clear from the figures above that it is much lower over our period. The annualised ten year ERP using gilts up to five years is the only one which comes close to matching that figure.

It is interesting to compare this with Damodaran , p. Estimated Equity Risk Premia Damodaran , p As we can see these Equity Risk Premium are in a narrow range and cover a number of different time periods and surveys. Our Equity Risk Premium historical data covering a period of thirty five years is consistently lower than these estimates, with only the ERP calculated on annualised Gilts Up to 5 Years , falling within the range.

Again we have to consider the short time frame we are using data from but it does suggest that there is still a tendency to overestimate the risk premium. In a previous article we looked at the possibility of using interest rate swaps, adjusted for risk, as replacing gilts as the risk-free benchmark. To add to this, I would like to look at some specific short dated gilts and LIBOR.

As we read, LIBOR is key to the process and it is interesting to look at some examples over our period to compare with the return. The inputs for understanding Equity Risk Premium historical data all vary in terms of the number of years available; I have therefore chosen data from the end of and will compare eight separate items which could be deemed as the risk-free rate.

The purpose of this is to compare the various options for a risk-free rate and to highlight that the traditional method of measurement is changing. This is purely for comparative purposes and the work on my data in the remainder of this paper will be on gilts, as already explained. To be consistent I will pick the rates, as far as possible, from the last trading day of December.

As we can see from the figures above, there are a number of alternative risk-free rates. We must remember though that there will not be universal acceptance of all of these options being risk-free. The key factor here is to determine which rate is the most relevant to the investment being considered and from this the risk premium may be determined.

To conclude this article we have established that the Equity Risk Premium, for our time period, is lower than the consensus view of 6. The return on equities is also more closely correlated to the return on gilts of longer duration, again as proposed by Dimson et al Finally we have examined some options for a risk free rate rather than traditional gilts and it is apparent that there are a number which can be chosen. In my next article we will move on to look at the Prospective Equity Risk Premium.

No position in any of the mentioned securities at the time of publication. Any opinions expressed herein are solely those of the author and do not in any way represent the views or opinions of any other person or entity. Model Portfolios and Total Cost of Ownership FinalytiQ Paraplanners. Can Risk Premium Be Negative Before Investment Manage Bitcoin. When Does The London Stock Exchange Close For Xmas Penny Stocks. Free Minecraft Premium Account No Survey provide -surveys for cash.

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Equity Risk Premium Historical Data: Not Investment Advice — Please read investment disclaimer. Tagged equity analysis equity risk premium stock market analysis. Model Portfolios and Total Cost of Ownership FinalytiQ Paraplanners markyu.

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