Interest Rates and Equity Returns: What’s the Relationship?
Over long periods, stock markets often deliver returns above prevailing risk‑free interest rates. A common rule of thumb is that equities may return interest rates plus an equity risk premium.
Fed/RBI Policy Rates and Stock Market Returns
Think of equity returns as: Expected Equity Return ≈ Risk‑Free Rate + Equity Risk Premium. Many investors use a rough premium of ~6–7% as an illustrative guide. Returns aren’t linear year‑to‑year — markets rise and fall — but over long horizons they can average out near this spread.
US Example
If the Fed Funds Rate ≈ 3%, the long‑run stock return expectation might be around ~9–10% (≈ 3% + 6–7%). Not a promise — just a planning anchor.
India Example
If the RBI Repo Rate ≈ 7%, a rough market return guide could be ~13–14% (≈ 7% + 6–7%) over long periods, subject to cycles and earnings growth.
Key Caveats
- Equity risk premium varies by era, valuations, and inflation.
- Returns arrive in lumps, not straight lines.
- Country, currency, and sector mix matter.
Quick Mapping (Illustrative)
| Risk‑Free / Policy Rate | Illustrative Long‑Run Equity Return |
|---|---|
| 2% | ~8–9% |
| 3% | ~9–10% |
| 5% | ~11–12% |
| 7% | ~13–14% |
| 9% | ~15–16% |
How to Use This in Practice
- Estimate today’s risk‑free rate (e.g., Treasury bills in the US, short‑term G‑secs in India).
- Add a conservative equity premium (e.g., 5–6% if you want to be cautious).
- Compare with your portfolio’s required return; adjust asset allocation accordingly.
- Revisit assumptions yearly; premiums shift with valuations and inflation.
Bottom Line
Policy rates set the “starting line,” but earnings growth, valuation changes, and inflation drive the finish. Use the rate + premium model as a guide, not a guarantee.
This page offers general education, not investment advice. Markets are risky; assess your goals and risk profile or consult a professional.