When Are Equity Investors Paid To Take Risk?

Most gauges of “the” equity risk premium have declined since the financial crisis but remain elevated, even as broad market indexes near record highs. The implication for investors seems simple; they can expect to be rewarded handsomely for bearing equity risk, relative to holding Treasuries. Lessons for central bankers may also appear straightforward. Sizable premiums could imply that aggressive unconventional monetary policy hasn’t necessarily eased financial market conditions satisfactorily.

However, my recent New York Fed staff report suggests that such a cursory reading ignores the term structure of equity premiums, which conveys a subtler story about more precisely when over the investment horizon investors get paid to take risk and how monetary policy accommodation may have affected stock prices.

Why Do Equity Premium Term Structures Matter?

For starters, to speak of “the” equity risk premium may be as egregious a grammatical error as “the” interest rate. Just as the yield curve contains a wealth of information beyond any single point, market participants’ required compensation for equity risk might vary with investment horizons. The key is that investors make decisions over multiple rather than single periods or, in technical terms, they must solve a dynamic as opposed to a static asset allocation problem.

To illustrate, let’s consider investing in the stock market from September 29, 2008—the day the Emergency Economic Stabilization Act (EESA) failed to pass the U.S. House of Representatives—through the next day. Intuitively, investors demanded handsome compensation for owning shares relative to risk-free Treasuries over that short, harrowing interval. Now consider a much longer horizon beginning on the same day, September 29, 2008, but ending, say, in 2108. The amount and price of the risk stemming from the uncertain fate of the EESA figures no less profoundly, but for the bulk of the remaining 100 years market participants conceivably penciled in lower demanded “forward” compensation for buying stocks. So, the required rewards to owning shares over the century beginning on September 29, 2008, may well have been substantially front-loaded. This doesn’t imply any irrationality among investors, but simply that risk perceptions and/or preferences were distributed differently at various points in the future. Furthermore, nearer-term cyclical considerations aren’t the only motivation for specifying the full horizon of equity premiums, as some factors might affect the back end more than the front section of the term structure, such as comparatively glacial demographic trends in retirement savings.