Equity risk premium (Aktienrisikoprämie)

Level 3 · Advanced

German termAktienrisikoprämie

Read firstAsset classes · Risk vs. volatility · Risk-free rate

Deep divesStocks

The equity risk premium is the extra average return stocks are expected to earn over a risk-free rate (the return on virtually default-free government debt) to compensate investors for holding a riskier asset. It is a forward-looking expectation, not a guarantee — the only way to measure it after the fact is by comparing long-run stock and bond returns, and even that historical figure shifts with the period chosen.

Why it matters

Anyone splitting savings between a Tagesgeldkonto (instant-access savings account), government bonds, and a global stock ETF is implicitly pricing this premium. Stocks (an asset class) swing far more than risk-free instruments do, and the premium is the extra return investors require to accept that volatility (the size of the swings) instead of settling for a safer, lower-returning asset. Without this concept, "stocks return more over time" looks like a fact of nature; with it, the extra return is a price — compensation for a specific, quantifiable risk, not a free lunch.

Worked examples

1. The premium as a spread, not a fixed number. The equity risk premium moves together with whatever the risk-free rate happens to be — it is a gap between two returns, not an absolute figure.

Scenario (illustrative)	Risk-free rate	Expected stock return	Equity risk premium
Low-rate environment	1%	6%	5 percentage points
Higher-rate environment	3%	8%	5 percentage points

In both rows the premium stays at 5 percentage points even though the risk-free rate triples — the premium tracks compensation for equity risk, not the absolute level of interest rates.

2. Sizing the trade-off for a saver. A saver holds €10,000 and compares a Tagesgeldkonto paying an illustrative 2% against a global stock ETF with an illustrative long-run expected return of 7%. The 5-percentage-point gap (7% - 2%) is the equity risk premium on offer. Over one year that gap is worth an illustrative €500 in expected extra return (5% x €10,000) — but "expected" is doing the work: in a bad year the stock allocation can lose 30-40% of its value in a way the Tagesgeldkonto structurally cannot, since a savings account balance is not exposed to market price swings the way a stock holding is.

Check yourself

A government bond (the risk-free rate) yields 2.5%. A global stock ETF has an expected long-run return of 7.5%. What is the equity risk premium, in percentage points?

An investor says: "The equity risk premium is 4%, so stocks are guaranteed to return exactly 4 percentage points more than bonds this year." What is wrong with this statement?

Nothing — the equity risk premium is a guaranteed extra return each year.The equity risk premium is a long-run average expectation, not a guaranteed outcome for any one year.The equity risk premium should be expressed in euros, not percent.Stocks always underperform bonds, so any premium figure is meaningless.

Which of the following statements about the equity risk premium are accurate? (Select all that apply.)

It represents compensation for taking on higher volatility and loss risk relative to a risk-free asset.It is defined relative to a risk-free reference return, not measured in isolation.A higher risk-free rate automatically produces a higher equity risk premium.It can be known with certainty in advance.

In Scenario 1, the risk-free rate is 1% and expected stock return is 6%. In Scenario 2, the risk-free rate rises to 3% and expected stock return rises to 8%. What happened to the equity risk premium between the two scenarios?

It rose, from 5 to 7 percentage points.It stayed the same, at 5 percentage points in both scenarios.It fell, because rising interest rates always shrink the equity risk premium.It cannot be determined without also knowing the inflation rate.