US), the ERP can be quite high due to the perceived stability of the market, while in more volatile markets (e.g. emerging markets), the ERP may be much lower as investors demand a higher premium for taking on additional risk.
In Greece, the ERP is significantly higher, at approximately 10%, (compared to about 6% for the US), which reflects the economic disruptions experienced by the country in recent years.
Some people believe that ERPs should vary for different time periods, with a range of about 3-3.5% over a shorter time frame and as much as 5.5% per year over a 30-year period in the case of US markets.
Historical Patterns
The expected return assumption can be based on past historical return patterns (which may or may not repeat themselves).
Besides only extrapolating historical returns, one could use a re-working of the Gordon Growth Model to find a value for “g” (the future growth rate of dividends as a proxy for future growth) or take the earnings yield of an equity (the inverse of the P/E ratio, where a P/E of 20 equates to an earnings yield of 5%) as a growth forecast.
However, neither of these measures allows for a change in valuations, suggesting that market peaks and troughs do not occur, which is clearly untrue.
By using any of these methods, one can establish long-term expectations for the future returns of an asset and, from that, decide on the asset allocation of an entire portfolio.
Based on this, one might consider allocating more capital to equities since they typically provide higher per-unit compensation for risk than alternatives such as bonds.
However, currently, the higher ERP may be purely a function of the widening gap between the expected market rate of return and risk-free rates; the long period of near-zero risk-free rates of return may not last indefinitely, and thus the ERP may decline not due to any macroeconomic factor (or market estimation of risk), but simply as the spread between the two metrics narrows.
This has resulted in abnormally high equity returns relative to bonds in the last decade or so, (implying a higher ERP than may be appropriate), which has become known as the Equity Premium puzzle, for which no satisfactory explanation has yet been developed.
The ERP can be a useful guide to future returns but should not be relied upon as a forecast since it heavily depends on all the formula’s components remaining stable, which they do not.
A high ERP may indicate high future returns, but there are no guarantees.