Equity Risk Premium in India

The empirical regularity that stocks provide a higher return than government bonds is known as “equity premium” puzzle, a term first coined by Mehra and Prescott (1985). The most intuitive answer that stocks are riskier than Bonds is not a sufficient explanation for this observed puzzle. Moreover, this equity risk premium (ERP) epitomizes the investor risk aversion. A person if given a choice between a low but sure payoff and a high but uncertain payoff would choose the guaranteed payoff if he is risk-averse. Given the expected utility of both the scenarios are same, a risk-neutral person would be indifferent between the choices.
However, the presence of equity risk premium (ERP) exemplifies that investors are largely risk-averse. Because arbitrage by investors should have eliminated (or reduced) the return difference between these two investment opportunities which is not the case in the present case.

Table-Equity Risk Premium in India 2000-2016
Year
BSE500
Yield on 10 Year Govt. Bond
Premium
2000
-27.17%
11.04%
-38.22%
2001
-22.91%
9.37%
-32.28%
2002
16.99%
7.20%
9.80%
2003
101.10%
5.60%
95.49%
2004
17.47%
5.93%
11.53%
2005
36.56%
6.97%
29.59%
2006
38.85%
7.66%
31.19%
2007
63.02%
7.95%
55.07%
2008
-58.14%
7.85%
-65.99%
2009
90.23%
6.95%
83.28%
2010
16.35%
7.85%
8.50%
2011
-27.41%
8.37%
-35.78%
2012
31.20%
8.30%
22.90%
2013
3.25%
8.20%
-4.95%
2014
36.96%
8.56%
28.40%
2015
-0.82%
7.75%
-8.57%
2016
3.78%
7.18%
-3.39%
Mean
18.78%
7.81%
10.98%


This table shows annual returns of S&P BSE 500 index during 2000-2016 and the average yield on 10-year government bond obtained from Investing.com. 10 out of last 17 years have provided a positive equity premium.  On the other hand, the equity premium is negative in rest of the 7 years. However, on an average, the risk premium is 10.98% during the sample period. I would like to add a caveat here that it is very easy to fall victim to the fallacy of average, as the standard deviation of the ERP is 42.4%, which is quite high. 
As Nassim Nicholas Taleb puts it very eloquently: "Don't cross a river if it is four feet deep on average". Although the ERP is 10.98% on average during the last 17 years, there is a lot of volatility in it. For example. in 2008 (which is the period of the financial crisis), the ERP is -65% or an investor who was expecting a return of 10.98% above the risk-free rate may have ended up eroding his investment by 65%. Or take the example of the latest two years. Both in 2015 and 2016 the ERP is negative. Therefore, investors would have been better off if they would have invested in Govt. Bonds instead of equity market in these two years. But again this statement is true only ON AVERAGE. 




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