What does the equity risk premium represent?

The equity risk premium represents the excess return that investors expect to receive from investing in a risky equity asset compared to a risk-free asset, typically represented by government treasury bonds. This concept captures the additional compensation that investors demand for taking on the higher risk associated with equity investments as opposed to holding a risk-free asset.

Specifically, it indicates the return that equity investors seek over and above the return of a risk-free investment, reflecting the risks associated with fluctuations in the stock market, company performance, and broader economic factors. This premium is a critical component in asset pricing models, such as the Capital Asset Pricing Model (CAPM), which helps assess the expected returns on investments relative to their risks.

In contrast, the return from a risk-free asset is a baseline measure and does not factor in the added risks of equities. Total return from a diversified portfolio may not specifically isolate the equity risk premium, as it includes returns from fixed income and other asset classes as well. Expected returns based on market volatility can influence the premium but do not define its core meaning, which is fundamentally the extra return for accepting equity risk.