Is equity risk premium crucial for your investment decisions?

Investors may use the equity risk premium as a gauge to decide their asset mix as well. The higher the equity risk premium, the more the odds favour investors tilting their portfolio in favour of equities (away from bonds), said Gaurav Doshi, principal officer – IIFL Wealth Portfolio Managers.

When this metric is calculated for each country considering the risk differences for individual countries, it is called country risk premium.

While this diversification has provided some protection against some risks, with a varied range of investment options ranging from listings of foreign companies to mutual funds that specialize in emerging or foreign markets (both active and passive) and exchange-traded funds (ETFs), it has also exposed investors to political and economic risks that they are unfamiliar with, including nationalization and government overthrows, said Aswath Damodaran, a New York University finance professor in his paper Country Risk: Determinants, Measures and Implications.

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“When Siemens and Apple push for growth in Asia and Latin America, they clearly are exposed to the political and economic turmoil that often characterize these markets,” he added.

Thus, assessing the riskiness of the investment climate in the country in issue is the first step in deciding whether or not to invest overseas, said Sabyasachi Mukherjee, head Investment Products, Fisdom Private Wealth.

A key point to note when considering the equity risk premium for any company is the place where the operations are carried out, not where it is listed or located.

“If a global business listed in the US has majority of its offshore revenue from countries with macro risk, that should be accounted for in overall equity risk premium for the stock,” said Pratik Oswal, head of Passive Fund Business, Motilal Oswal AMC.

He emphasised the point by giving an example of LVMH, a listed company in France.

“LVMH is listed in France but is a global business with a global revenue model. It does not matter if its listed in Switzerland, Germany or even the UK. Tagging LVMH to a particular country’s equity risk premium may not be appropriate,” he added.

Since international investing is essentially done for diversification, in addition to equity risk premium, correlation is also an important factor.

“Correlation of returns among countries, should be examined as well, with a lower correlation being preferable in terms of risk reduction,” said Mukherjee.

Finding ERP data

Accuracy of the data as well as subjectivity in the calculation methodology makes it difficult for investors to really compute these metrics, said Oswal. Also, it is a dynamic metric with estimates varying wildly depending on the time frame and method of calculation. Since equity risk premium would also depend upon qualitative criteria, there are chances that two investors could arrive at non-identical results, added Sameer Kaul – MD & CEO, TrustPlutus Wealth. Mukherjee said that they choose to use Aswath Damodaran’s risk premium computation, which is sufficient for the risk premium calculation. “Other sites, like aqr.com, project asset class predicted risk/return, which retail investors may easily access to gain a helicopter view,” he added.