What is “Equity Risk Premium”?  

As an investor, it is a term you ought to know.

Buying investment vehicles, whether bonds or stocks, involves a degree of risk.  The entity needing money could ultimately go bankrupt, losing their investors’ money.

Governments and companies sell bonds.  Bonds include a prescribed interest rate.  If you hold onto a bond until the maturity date, you will be paid the original cost of the bond, plus the accumulated interest in the bond over the time from sale to maturity.

Bonds are generally considered reasonably safe.  Unless the seller ceases to exist – i.e., a business goes bankrupt or a country is somehow conquered – the debt owed to you will be paid off.

Some bonds – particularly U.S. Treasury bonds – are considered “guaranteed” or “risk-free”.  It is a safe assumption that the U.S. will still exist when the bond comes due.  If the U.S. government fails to function, the level of disruption and destruction that caused that failure would have to be so severe that getting your due payment from the bond will be the least of your worries.  

Even China buys U.S. Treasury bonds.

The interest rate for those guaranteed, risk-free bonds is considered the base-line for making money from your investment.  

Other bonds are not as risk-free, and so must pay you a higher rate of interest.  Cities or states that sell bonds cannot give buyers the same level of assurance as that of the U.S. Treasury.  Cities have gone bankrupt, and even some states have such high levels of debt that bankruptcy seems to be a possible consequence.  

Should bankruptcy occur, the money you invested in a bond is lost.

Businesses, of course, are generally more likely to go bankrupt than cities or states.  Bonds sold by businesses must be sold with an even higher interest rate than that of cities.

The most risky investments of all are stock purchases.  Stocks may pay dividends, but most investors expect a stock’s price to increase over time as a result of the growth of the company – more sales, more revenue, and more profit.  But even more sales and more revenue do not guarantee more profit.  In fact, a company can be too successful.  Sales can be so great that the company must invest in more factories to meet demand, but the cost of those factories can be too high for the company’s budget, bankrupting a successful company.  Mismanagement by the company’s executives can also lead to bankruptcy.

“Equity”

Another word for bonds and stocks is “equity”.  As an investor, your goal is to recoup your equity - your investment, plus a premium – interest or increased stock value – for the use of your money.

“Risk”

“Risk” in this case is the risk to you that you might lose your investment, and additionally that you might lose the premium you expect you will gain from your investment. 

“Premium”

Premium is the amount above and beyond your equity – the additional money you expect to receive – your profit.

“Equity Risk Premium”

Equity Risk Premium is the percentage amount of return which buyers typically expect for each type of investment – bonds or stocks, beyond the return of a risk-free bond.  

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