Is the equity risk premium dead?
Predictions about lower stock returns are making headlines, but investors are better served by disciplined rebalancing than by trying to forecast the market.
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Stocks are riskier than bonds, especially Treasury bonds. The theory goes that we are rational beings and want to be compensated for taking on more risk. That extra amount of risk is known as the equity risk premium. The formula is as follows:
Equity Risk Premium = Expected Return on Equity – Risk-Free Rate.
For example, if a 10-year Treasury bond yields 4% and investors expect a 10% return on stocks, the equity risk premium is 6%. By this, I mean investors want to be compensated an extra six percentage points to take on that additional risk over a virtual sure thing with that Treasury bond.
Evidence of a diminished equity risk premium
Lately, however, I’ve seen some observers saying that the equity risk premium is either gone or possibly now actually a discount, meaning investors expect stocks to earn less than bonds. To illustrate, the 2025 Vanguard Capital Markets Model forecast a 10-year average annual return on US equities between 2.8% and 4.8%, while it forecast US bonds to earn between 4.3% and 5.3%. Its most recent forecast, however, had US stocks besting bonds by a small 1.2 percentage points annually. In January 2026, a Vanguard commentary stated, “Our strategic allocation of 40% stocks and 60% bonds reflects our own assumptions about investment horizons, long-term capital market return projections, and risk tolerance.”
A May article in The Wall Street Journal titled “The Risk Premium for Holding Stocks Over Bonds Is Vanishing” also made similar points as Vanguard. It used a different metric for the equity risk premium as “the gap between the S&P 500’s earnings yield—the profit companies generate relative to stock valuations, expressed as a percentage—and that of the 10-year Treasury note.”
What it would mean
Because stocks are always riskier than Treasury bonds, the implication of the above arguments is that stocks are grossly overvalued. Perhaps the best measure of market valuation is the US — S&P 500 Cyclically Adjusted Price-Earnings Ratio, which is calculated by dividing the current price of the S&P 500 by the 10-year moving average of its inflation-adjusted earnings. Nobel Prize-winning economist Robert Shiller developed the CAPE ratio back in 1988 using data going back to 1881. This is known as backtesting the data, which I refer to as predicting the past. The CAPE ratio was very predictive of future stock returns over the following decade. The chart below shows the CAPE excess yield and subsequent return over the next decade. Excess CAPE yield is defined as (1/CAPE ratio) minus real 10-year bond yield. It worked brilliantly for a bit going forward until about the last decade and a half, when it predicted muted stock returns during a period that stocks surged. In other words, relying on this as a market-timing mechanism would have been costly.
Excess CAPE yield and subsequent 10-year annualised excess return
Of course, whenever one market-timing model fails, others emerge, such as a tweak of the CAPE known as theCC CAPE ratio by Research Affiliates. This also is based on backtesting. Larry Swedroe recently wrote about another fix to forecasting models that failed going forward.
The irresistible urge to predict the future
According to the CFA Institute, the equity risk premium has averaged 6.2% annually from 1926 to 2024. It also notes that it peaked at 10.6% from 2015 to 2024, right when the CAPE ratio indicated stocks were overvalued and to expect muted returns. As Jason Zweig, who writes the Intelligent Investor column for The Wall Street Journal, once wrote, we humans have an addiction to predictions. He notes that our brains are wired to find patterns. When the market goes up or down, our brains crave a logical reason why it happened. This makes us desperate to know what will happen in the future.
While the arguments for the diminished equity risk premium are far more grounded in academia than in simply asking so-called experts what they think stocks will return, they are essentially the same thing. They are using patterns that worked in the past to predict the future.
The bottom line is that stock market valuations reflect the collective knowledge of all investors. Market-timing, whether based on gut feeling or sophisticated models such as any version of the CAPE index, doesn’t work. You have to figure out when to sell and when to get back in.
Discipline is better than predicting the equity risk premium
Let me first confess that I don’t know how equities will perform next year or the next decade. I do know that stocks are riskier in a day than high-quality bond funds are in a year. This is illustrated by the more than 20% plunge on Black Monday in 1987. Granted that we are all irrational at times, but overall, we are rational enough to demand a higher return for accepting higher risk.
I’ve been recommending to most clients that they reduce that risk by selling some equities. That recommendation is not based on my gut feeling (as a pessimist, I always feel stocks are overvalued), any sophisticated model predicting returns, or the future equity risk premium. It’s based on rules I tell clients to follow no matter what people are predicting. For example, if one set a 50% allocation to stocks and a 6-percentage-point tolerance, one would have to sell some stocks when they accounted for 56% of the portfolio. One would have to buy if they became less than 44%. Because stocks have surged over the past few years, rebalancing required selling stocks.
In conclusion, in spite of how unsettling it feels, accept the fact that we don’t know future returns or the current equity risk premium. Have the discipline to follow rules and ignore what you think are indicators of the future, no matter how academically based those indicators are.
