The equity risk premium (ERP), the extra return investors demand for holding equities over risk-free assets, is at its lowest level in years, and it’s flashing yellow lights across institutional dashboards.
Stern Business School Professor Aswath Damodaran noted that the implied ERP for the S&P 500 dropped to just 4.21% in July. That number shows that investors are taking on more risk for a lower potential reward.
The danger? Risk that’s mispriced is often misunderstood. And that opens the door to bad decisions by both retail traders chasing the dip and institutional investors managing billions.
A Dynamic Compass
The ERP represents the expected return on equities over and above the return on a risk-free asset, typically long-term government bonds. It’s a core building block in asset pricing models — from the capital asset pricing model to the discounted cash flow (DCF) — and is essential for estimating the cost of equity, valuing companies, or evaluating the attractiveness of stock markets versus bonds.
Damodaran estimates the ERP using an implied approach, which involves backing out the …