Last week I talked about style premiums and the different types we use to diversify portfolios. Today I will focus in on one in particular: the equity premium.

What is it?

The equity premium is basically how much the total stock market returned minus the risk-free rate. How does one determine the “total stock market”? In Academia, many utilize the Center for Research in Security Prices (CRSP) to analyze equity performance over long periods of time. The CRSP is a large collection of stock price performance data from the University of Chicago. Some define the total stock market as all the stocks in the CRSP (sometimes referred to as “CRSP 1-10”). An index proxy for the academic version of the total stock market is the Wilshire 5000 – a market-cap weighted index that includes all companies actively traded in the US. The risk-free rate is normally defined as one-month treasury bills. The reason for subtracting the risk-free rate is simple: if you are going to invest your money, you will at least get the risk-free rate of return. The equity premium describes how much return above the risk-free rate you would expect to yield if you invested in every US stock weighted by market cap.

The Numbers

In the US from 1927-2012, the equity premium was 7.88% with a standard deviation (a measure of volatility) of 20.18%. The equity premium is both large and volatile. In fact, it is so volatile that you need about 30 years of data to even be confident (statistically) you will receive a positive return.

We have data for developed international markets going back to only 1990. The equity premium from 1990 to 2012 was 5.88% with a standard deviation of 18.25%. With such a small sample set it is hard to draw any conclusions about whether international or US markets are superior investments. However, it does suggest that the equity premium exists in different markets and will continue in the future.

Why It Exists

The equity premium is no doubt a risk story. Investing in stocks is riskier than investing one-month treasury bills. Over the last 85 years US investors have been rewarded for taking this risk. It has not always worked out so well; the stock market can be negative for long periods like it was for the 13-year period of 1929-1942. It can also have large losses in short periods like the 56% loss from October 2007 to March 2009 or the 88% loss from September 1929 to July 1932. (Ouch!)

How To Capture It

Gaining exposure to the equity premium is pretty easy in today’s market. There are numerous investments designed to gain passive exposure to US, international developed and emerging markets. You can even gain exposure to the entire world’s equity premium by investing in a global fund like Vanguard’s VTWSX which holds about 8000 stocks from 47 countries. It has an expense ratio of only 0.35%.