JAMES P. WESTON: Hi. Welcome back to finance for non-finance professionals. This week, we're talking about the cost of capital or what discount rate to use. In this lesson, we're going to talk about the equity risk premium. What is it? And roughly what ballpark numbers sound good? What we learned from the last lesson was that stocks tend to do better in the long run. But you might need 50 years for them to out run other kinds of investments, because they wiggle around so much. Stocks are really risky. They have huge volatility, and so there are lots of periods where I would go 5 years, 10 years, sometimes 15 or 20 years, where the stock market actually underperformed bonds, and I might have to wait a long time. That tells me that if I'm an investor, and I'm thinking about putting my money in the stock market, it feels risky to me. I'm not as willing to be patient, not knowing what's going to happen to my money over the next 5, 10, 15, 20 years. If I could live 200 years, and do that 1,000 times, I would always put all my money in the stock market. But since I'm only doing it one time, I'm worried that 5 years or that 10 years is going to be the one where the stock market goes down. So what does that mean? I'm going to require a premium. I'm going to require a risk premium over the risk-free rate to compensate me for taking that stock market risk. Higher discount rates, higher risk. When we looked at the data in the last lesson, stock markets went up around 10% to 12% on average over the last say, roughly 100 years. And if we go back even further using some longer run historical data, those numbers don't flop around too much. 10% to 12% seems like what stock markets tend to return over the long run, on an annual basis. Interest rates-- if you remember our discussion of the risk-free rate-- we said interest rates were usually around 5% or 6%. Even going back some time to ancient Rome, we could say interest rates were often around 6%. If stock markets on average tend to earn around 10% to 12%, and interest rates tend to be around 5% or 6% that tells us that wedge between risk-free rates and stock market returns gives us what we call the equity risk premium, which is the return on the market less the risk-free rate. That 10% to 12% minus that 5% or 6%. If I take that roughly 11% return on the market, and that roughly 5.5% interest rate, on average that tells me that the equity risk premium is around 5.5%. That's an important number. What that number tells us is how much I should require for putting my money in stocks, in general. What's the price of stock market risk as a whole? That price of stock market risk as a whole, is around 5.5%, plus or minus. That's not a precise number, but plus or minus around 5.5%. That's what we call the equity premium. How much does an investor require to put their money in the stock market overall? What's the price of stock market risk? It's around 5.5%. That's a long-run historical average. Does that seem like a reasonable rate? It should, because what we as investors think of is how much am I going to have to pay you to be patient with my money if I'm putting my money in the stock market. Investors seem to think a reasonable rate over the long run, on average, is around doubling the risk-free rate. If the risk-free rates are around 5.5% to 6%, I would require at least double that to earn 11% or 12% in the stock market. If you survey market professionals, or analysts, portfolio managers-- people that manage money and put their money into the stock market professionally-- what do they think the equity premium is? Different methods, different historical averaging, gives a range of around 4% to 8% as the equity premium. Our historical rate was around 5.5%. Market professionals think, if you survey them, they line up somewhere around 4% to 8%. I wouldn't view that as too big of a range, I actually think that's kind of nice that they come in sort of a relatively tight range, 4% to 8%. So I would say 4.5% to 6% is a good range for the equity premium. What might make that premium change? It doesn't always have to be the same. Think about what might make it-- if we just went through a financial crisis, everyone's attitude towards risk might be a little bit more shy. I might be a little bit more reluctant. I might not feel as comfortable putting my money in the stock market after some really big, bad event-- like the equity premium seems to go up after the oil crisis, it seemed to go up after World War II, it seemed to go up after the financial crisis in 2008. Attitudes towards risk, as they shift around, equity premiums might shift around, as well. All of those change the price of equity risk, and they move it from that lower part of the range 4.5% up to that higher part of the range, maybe 6.5% to 7%. Stock market as a whole, just to sum up, is a well-diversified portfolio. So here, when we talk about the equity premium, I'm not talking about putting your money into General Electric stock, or IBM stock, or Facebook stock, I'm talking about putting your money into the equity market as a whole, into a well-diversified portfolio. That risk-- putting the money into the stock market overall-- is around 4.5% to 6.5%. That 4.5% to 6.5%-- that risk premium, should compensate me for taking equity risk in general-- for taking stock market risk. On average, 5.5% is the number we'll use going forward, and that's going to be our price of market risk. That's going to be our equity premium, 5.5%. But just remember that that could wiggle around, plus or minus 1% or 2%, but 5.5% is what we'll call the equity premium that compensates me for taking general stock market risk.
