The equity risk premium (ERP) is a fundamental concept every investor should grasp—especially as Australia’s financial landscape evolves in 2025. Whether you’re managing your own super, picking shares, or weighing up your asset allocation, understanding the ERP can help you make sharper, more informed decisions.

What Is Equity Risk Premium?

At its core, the equity risk premium represents the extra return investors expect to receive for taking on the higher risk of investing in shares over a ‘risk-free’ asset, such as Australian government bonds. In other words, it’s the compensation for the uncertainty, volatility, and potential for loss that comes with equities.

In 2025, with the RBA cash rate stabilising after a period of volatility and government bond yields hovering around 3.8%, the ERP is particularly relevant. For instance, if the expected long-term return on the ASX 200 is 8.5%, the ERP sits at roughly 4.7% (8.5% – 3.8%).

Risk-free rate: Typically the yield on 10-year Australian government bonds
Market return: Expected average annual return of the share market
ERP calculation: Market return minus risk-free rate

Why Does the Equity Risk Premium Change?

The ERP isn’t a fixed number—it shifts with market sentiment, economic cycles, and policy changes. In 2025, several factors are influencing the ERP in Australia:

Inflation: Although inflation moderated to the RBA’s 2–3% target by early 2025, lingering uncertainty means investors still demand a healthy premium for equities.
Interest Rates: With the cash rate stabilising after aggressive hikes in 2023-24, the risk-free rate has found a new normal, directly impacting ERP calculations.
Global Volatility: Ongoing geopolitical tensions and supply chain issues continue to inject volatility into markets, which can push the ERP higher.
Government Policy: The 2025 Federal Budget introduced incentives for tech and renewable sectors, making some equities more attractive and affecting their perceived risk.

For example, in late 2024, the ERP spiked as markets reacted to global banking sector wobbles. By mid-2025, greater policy clarity and improved corporate earnings steadied the premium, but it remains higher than the decade average.

How the Equity Risk Premium Impacts Your Investment Decisions

Understanding the ERP is essential for portfolio construction and risk management. Here’s why it matters for Australian investors in 2025:

Asset Allocation: A higher ERP may justify a larger allocation to shares, as the expected reward for risk increases. Conversely, a lower ERP could prompt a tilt towards bonds or cash.
Valuation Models: The ERP is a key input in models like the Capital Asset Pricing Model (CAPM), which analysts use to value companies and forecast returns.
Superannuation Strategies: Many Australian super funds adjust their growth/defensive split based on ERP forecasts, aiming to balance long-term growth with risk tolerance.

Real-world example: Suppose you’re considering an ETF that tracks the ASX 200. If the ERP is high due to market pessimism, the shares may be undervalued, offering a potential buying opportunity. On the other hand, a low ERP could signal that shares are expensive relative to bonds, warranting caution.

Looking Ahead: ERP and Market Trends in 2025

With Australia’s economic outlook stabilising, but uncertainty lingering globally, the ERP will remain a crucial metric for both retail and institutional investors. Expect further adjustments as new policies—like the government’s superannuation tax reforms and incentives for green investments—take hold through 2025.

Staying informed about shifts in the ERP can help you anticipate market movements, fine-tune your asset allocation, and avoid common investment pitfalls.