Investors in global equity markets have been well rewarded historically for bearing equity market risk. Over the period from 1900 to 2014, a dollar invested in global equity markets generated a return that is 38 times larger than the return on global government bonds and more than 120 times larger than the return on short-term government bills. While equity markets have experienced periods of extreme volatility, the spread between the return on equities and the return on government bonds has averaged 4.5 percent per year. The spread between the return on equities and the return on short-term government bills has been even larger, averaging 5.7 percent per year.
This large and positive excess return of equities over bonds underscores the wealth-building potential of equities over time, and the central importance of the equity risk premium (ERP) in portfolio investment decisions.
In this discussion note, we review the extensive theoretical and empirical evidence on the ERP. We describe the distribution of the realised ERP across different markets and time periods, and estimate the forward-looking (expected) ERP using a variety of models, including fundamental-based, regression and discounted cash flow models. We discuss the vast theoretical literature on the ERP and various explanations that researchers have put forward to explain the observed magnitude of the ERP and its behaviour over time.