By Jack Hough
There are certain things that friends should never say to each other, and I'm pretty sure "equity risk premium" is one of them. So, when a fellow 401(k) squirreler confided that his stash is looking pleasingly fat but is now overloaded in stocks, and that he'd like to move a chunk into something safe paying 4% to 5% a year, I kept my response business-casual: "Makes sense, Moneybags."
I didn't mention that he had brushed up against a cornerstone of modern finance, the equity risk premium, brought up to me earlier in the week as something of a warning by a chief investment officer overseeing $29 billion. Let me break it down here, partly to touch on where things stand for stock investors, and partly so that those unfamiliar with the concept will know what it means -- and doesn't mean -- if they encounter it in the wild.
Start with Goonies. Yes, the 1985 Steven Spielberg adventure, early in which Mikey, from his porch, opens the front gate for Chunk using a device that employs a bowling ball, bucket, balloon, chicken, football, and sprinkler. This, of course, is an example of a Rube Goldberg machine -- an overly complex mechanism that performs a simple task. The equity risk premium is a lot like the Goonies gate opener, only maybe not as reliable.
Mathematically, it's often written like this: ERP = E(Rm) -- Rf, which means that the equity risk premium is equal to the expected return of the market, minus a risk-free rate. If you expect the stock market to return, say, 10% a year, and if you can instead buy something that pays a guaranteed 4%, then your compensation for dealing with the chaos of the stock market -- the ERP -- is 6%.
There's just one problem: You can't bake a certainty pie if your ingredients include I-don't-know berries. We can't truly know the ERP unless we know what the market will return, and if we knew that, we wouldn't have to fiddle with theoreticals about whether we're being compensated enough. Think of the ERP as merely a loose framework for judging the relative appeal of stocks versus safe bonds.
If you wish to use the ERP to tell whether the stock market is a good deal, you'll have to do the best you can with expected market returns. One option is to use historical average returns, but that says nothing about whether stocks are expensive or cheap now. Another is to take a survey, but that just outsources the guessing. The Federal Reserve uses a method that at least benefits from clarity and consistency.
Twice a year, each May and November, the Fed publishes a Financial Stability Report that sizes up risks to the financial system. It includes a chart of the ERP. To calculate it the Fed way, take the stock market's forward earnings yield and subtract the real, or after-inflation, 10-year Treasury yield. Earnings yield is just a year's worth of estimated earnings divided by the market's price level -- an upside-down price/earnings ratio, in other words -- expressed as a percentage. I recently got 4.7% for the S&P 500 index.
For the real Treasury yield, you can just use the 10-year Treasury inflation-protected security yield, recently close to 2%. Putting it all together, the market's 4.7% earnings yield minus the 2% real risk-free rate gives an ERP of 2.7%.
We're still baking with I-don't-know berries, because the market's earnings yield is by no means a slam-dunk predictor of future returns. The actual number you get isn't what matters most. Since the approach is consistent over time, you can compare the current number with its history. This being May, we just got a fresh Financial Stability Report, and in it the Fed notes that the ERP has "moved up a touch" but remains "near a 20-year low." Remember: The ERP represents a return an investor is getting, not a price he or she is paying, so unlike with the P/E ratio, higher in this case is good, and low is potentially worrisome.
The median ERP in Fed data since 1991 is 4.6%. The low, during the dot-com stock bubble, was negative. Stocks could easily push well higher now, especially because of explosive earnings growth from artificial-intelligence spending -- that's what has made the ERP a touch more attractive since November. Some people argue that the ERP was too high to begin with, and is naturally moving lower over decades as investors view the market as more dependable. I've called it buy-the-dip-itis, but could it instead be falling risk?
"I actually believe that what we're seeing is more about incredible euphoria or optimism than it is the extinction of the risk premium," says Brad Conger, chief investment officer of Hirtle & Co., an independent investment office for institutions and wealthy families. "People can be so excited about growth that they make bad assumptions."
Conger sees a risk that big AI spenders learn to do more with less, and growth slows, or that some of the buildout proves excessive, like fiberoptic cable that was laid too soon in the 1990s. "That's what really kills an economy, when you've malinvested a trillion dollars and somebody here, being the debtholders, has to eat it," he says. He recommends trimming tech holdings, rebalancing portfolios with more bonds, and adding exposure to Europe, not fleeing U.S. stocks altogether.
There you have it. If, against all odds, you have found the ERP fascinating, I recommend looking into something called the Capital Asset Pricing Model. It's a machine that can tell what a stock will return, only please don't use it for that, because it relies on the same I-don't-know berries as the ERP, plus some unicorn dust in the form of risk conjecture. In Goonies terms, that gate opener is so complicated that Chunk would still be waiting to get in.
Write to Jack Hough at jack.hough@barrons.com and subscribe to his Barron's Streetwise podcast.
To subscribe to Barron's, visit http://www.barrons.com/subscribe
(END) Dow Jones Newswires
May 15, 2026 21:31 ET (01:31 GMT)
Copyright (c) 2026 Dow Jones & Company, Inc.
Comments