Estimating the equity risk premium is the holy grail of investing. That’s because the allocation to the stock market is, for most investors, the primary driver of risk in the portfolio. As a general proposition, one can say that the allocation to equities will (for good or ill) go a long way in determining the portfolio’s return in the long run, and perhaps over the short- and medium-term horizons as well.
No wonder, then, that here’s a lot riding on the outlook for equity returns above and beyond the risk-free rate, which we can define as short-term Treasury bills or, if you prefer, the 10-year Treasury Note. With that in mind, it’s always timely to take a fresh look at what financial economics tells us about projecting the equity risk premium. As a preview, there’s still precious little that’s new under the sun in strategic terms. Yet researchers keep chipping away at the nuances of asset pricing, and every now and then they turn up intriguing and perhaps useful clues for peeling away another layer of uncertainty in projecting risk premiums.