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 expected return from current stock prices and comparing it to the risk-free rate. The result is a dynamic, market-based gauge of what investors believe equities should yield to justify the risk.
But it's easy to fall into traps when using ERP, Damodaran warns.
In his widely cited paper "Equity Risk Premiums (ERP): Determinants, Estimation and Implications," which he has been updating since 2008, Damodaran identifies common myths, including the idea that ERP is static or universal.
"There is no one equity risk premium," Damodaran writes. "There are many, varying across markets and even across sectors."
Investors who rely blindly on historical averages — such as the often-quoted 5.5% premium based on past U.S. equity performance — may be anchoring to a world that no longer exists.
Why ERP Matters Now?
The lower the ERP, the less compensation investors are getting for risk. And that has real-world consequences for both institutional and retail investors. At these levels, traditional valuation models like the DCF are strained.
In the July outlook, Pictet Asset Management analysts warn that the S&P equity risk premium is priced for "a return to a much calmer economic and political climate."
That's a polite way of saying buyer beware. Put another way, equities are priced for perfection, and anything short of that could mean a sharp correction.
"We feel that there is limited potential for further upside in U.S. stocks from here, even more so after the recent rally," Pictet noted.
What Happens If Rates Keep Falling?
With two dissents at the Federal Reserve for the first time since 1993, and rising political pressure from President Donald Trump, the central bank is facing growing calls to cut interest rates.
Markets are now pricing two rate cuts by the year-end, and the yield on the 10-year Treasury has slipped below 4.2%. If rate cuts continue, the ERP could fall further — but paradoxically, equities might not rally.
That's because lower ERPs compress the margin of safety for equity investors. If growth disappoints or inflation resurges, valuations built on cheap risk assumptions could unwind quickly. Right now, that game has shrinking cushions and high uncertainty.
For investors, both institutional and retail, it may be time to reassess how much risk they're truly being paid to take.
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Image created using artificial intelligence via Midjourney.
