Is Equity Risk Worth the Reward in a World of Higher Bond Yields?
Equities have an important role to play in a diversified allocation today, to help hedge against inflation and to navigate a lower-growth environment.
Higher bond yields are presenting tough questions for equity investors. While the risk/reward trade-off for equities might be less favorable than in the past, historical return patterns suggest that US stocks can still do well in this environment.
Making investment decisions about any asset is a function of risk versus reward. For investors in stocks, the equity risk premium (ERP) is a common way to measure the risk/reward trade-off. Simply put, the ERP is the excess return that investors expect to earn over a risk-free rate. It measures the compensation that investors expect for investments in stocks, which are generally seen as riskier assets than bonds or cash. A higher ERP signals that investors can expect a relatively greater reward from stocks than they would in a lower-ERP environment, and vice versa.
Is Today’s Lower ERP a Bad Signal for Stocks?
This year, the ERP for US stocks has declined. Our ERP metric shows the earnings yield of the S&P 500 minus the yield of the 10-Year US Treasury note, a proxy for the risk-free rate. That spread declined to 1.2 percentage points at the end of October, from an average of 3.1 percentage points between 2009 and 2022 (Display). The ERP has narrowed because rising interest rates lifted the Treasury yield from near-zero levels to 4.9% at the end of October.