When buying a security such as a share, every investor should have an expected return in mind. After all, companies can go bust and your money could be in the bank instead, so why take the extra risk of buying shares otherwise?
There are various ways to try and calculate this ‘required return’ – the best known method is the Capital Asset Pricing Model (CAPM). It suggests you start with a minimum risk-free return that you could get from investing in something with almost zero default risk: government IOUs, or gilts. After all, the British and American governments aren’t expected to go broke (yet).
Let’s say the yield on medium-term gilts is 3%. The equity risk premium is the extra return you demand from shares to make taking the risk of investing worthwhile. To try and work this out, CAPM tends to look backwards at past prices.
The answer will vary – emerging markets, for example, carry higher-risk premiums than Western markets (the US long-term figure is about 6%).