Do you want to invest in shares? You need to understand the equity risk premium

Julie Brownlee, Fsp Invest, 12 Dec. 2014

Tags: equity risk premium, investing, investing in shares, risks of investing in shares, shares, shareholder, invest in shares,

If you decide to invest in shares, there are risks that come with that.

One risk you need to be aware of is the equity risk premium.

So what is the equity risk premium?

Let’s take a closer look…

Where you stand as a shareholder

It’s risky investing in shares (or equities). As a shareholder, you’re last in line to receive payment.

If a company makes its money from selling goods or services, there are many other people who have a claim on the company’s money. This includes employees, suppliers, lenders and the taxman.

They all have to receive payment before you do.

When times are good, a company’s likely to do well and will usually have plenty of money left over to pay shareholders. But when times are bad, it’s another story. There might be no money left over.

To compensate you for the risk of ending up with nothing, investing in shares has to offer you the prospect of paying you more than if you held something safer. For example, you kept your money in a savings account or bought retail savings bonds.

So this extra return is a theoretical amount known as the equity risk premium.

How big is the equity risk premium?

This is a subject of considerable debate among professionals in the finance industry and academics.

Some believe its basis should be the excess return that shares have given over bonds in the past. Other believe its basis should be the expectations of future returns.

The equity risk premium tends to be at its highest when shares prices are cheap and at its lowest when share prices are expensive.

So there you have it, why you need to understand the equity risk premium if you want to invest in shares.

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