Why would investors take inflation plus 5% return on a 30-year bond, or inflation plus 10% on an equity portfolio, with the non-negligible risk of facing significant drawdowns over a 1-year horizon, if investors can accrue inflation plus 3% via simple 1-year deposits with top five banks with certainty? We believe that skilled managers can construct portfolios to deliver returns that will exceed inflation by 2% to 3% over time with an emphasis on yield and without taking excessive equity, credit or duration risk.
It’s about compensation for risk
Every financial student learns early in their studies about the importance of the Equity Risk Premium (ERP).
“The equity risk premium (ERP), or equity premium, is the difference in expected or realized return between an equity index and a reference asset, where the latter is usually a bond or bill portfolio considered to be “riskless”.
In this article we delve into the importance of the ERP and other asset class risk premia in the context of our day jobs: deciding on the optimal asset allocation to meet a given investment objective. However, instead of cash as a reference asset, we use inflation as the benchmark to beat, giving rise to the concept of the Real Risk Premium (RRP).