Searching for ERP

One of the tenets of modern finance is that risk and return are inextricably related as investors demand a premium (or excess return) for risking their capital. In respect to stocks, this excess return is referred to as the “equity risk premium” (ERP) and is measured as the difference in return between that of a broad stock market index and of high-quality government debt, such as treasury bills.

In the U.S. the annualized geometric ERP was 6.3% from January 1926 to May 2014. Costs aside, investors in U.S. stocks earned a 6.3% annual premium over T-bills as compensation for the uncertain outcomes of owning equities.

This uncertainty is seen in the massive range in the ERP over time. The best year on record is 1933, when a 53.5% premium was earned; the worst is 1931, when a 43.9% shortfall was tallied.

In almost 35% of calendar years, the U.S. ERP was in the red; in more than 10% of years, it dropped by 15% or more.

The variation over time in the ERP reflects a variety of economic factors, such as the ever-present business cycle, monetary conditions, infrequent systemic shocks and real economic growth rates.

ERP also depends on investors’ psychology, including their level of risk aversion, preference for consumption and perceptions of growth.

Periods of high-risk aversion historically have resulted in lower equities valuations and higher subsequent ERPs; periods of extremely low risk aversion, such as those that occurred in the late 1920s, 1960s and 1990s, have resulted in the opposite.

A deeper analysis suggests the U.S. experience since 1926 presents an overly rosy picture of the ERP. Professors Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School have calculated that the ERP for the U.S. was 5.5% per annum from 1900 to 2013. Keep in mind, though, that the U.S. stock market also has been one of the most successful in the world.

The ERP for 22 countries, excluding the U.S., averaged only 3.6% per annum. Canada posted a respectable 4.2% annual ERP.

It’s the future ERP – not the historical metric – that is so vital to investors and their retirement plans. Estimates for the expected ERP range from as low as approximately 2% a year to more than 5%. Overall, however, the consensus is that the future ERP will be lower than the historical U.S. experience.

With today’s paltry interest rates compressing forthcoming bond returns, Job 1 for financial advisors is accessing the full measure of the future ERP for your clients. As a starting point, this means investing globally because markets outside North American have lower valuations and a higher expected overall ERP.

Second, because it is a mathematical reality that investors as a group earn the equities market return minus the costs, you must reduce unnecessary management fees and expenses for your clients at every opportunity.

Fortunately, competition is pushing fees down. Nowhere is this more evident than in exchange-traded funds (ETFs) that track broad market indices.

It’s now possible to diversify globally in more than 8,000 stocks via ETFs with a total management expense ratio of less than 0.1% a year.

The global ERP is there for the asking.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own securities mentioned in this article.