What is meant by Equity Risk Premium?

The equity risk premium refers to the excess return that investors can expect to earn by investing in stocks over a risk-free rate, typically represented by government bonds. This concept is crucial in finance because it provides insight into the additional risk that investors take on by investing in equity markets compared to safer investments.

When investors choose to put their money into equities, they do so with the expectation that the potential for higher returns compensates them for the additional risk of volatility and the uncertainty of stock performance. The risk-free rate, often associated with Treasury bills, serves as a baseline for this comparison. The difference between expected equity returns and the risk-free rate constitutes the equity risk premium.

This definition underscores the nature of investing in equities as a higher-risk endeavor than fixed-income securities. The concept emphasizes that the possibility of higher rewards is intrinsically linked to accepting higher risks, which is fundamental in portfolio management and asset allocation strategies.