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Is equity risk premium crucial for your investment decisions?

The equity risk premium is an estimation of excess return one can earn by investing in stock market over a risk-free instrument, such as government securities. It is calculated by using various quality and quantitative factors to arrive at the premium.

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 of 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.

“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.

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.

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

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