Dissecting The Historical Equity Risk Premium For Clues About The Future

What is the historical equity risk premium? It’s a simple question, and a crucial one. Looking at the past alone is no panacea for predicting the future, but it’s an obvious place to start. If you’re focused on making informed decisions about portfolio design and management, understanding where capital markets have been provides some useful context.

That’s where the simplicity ends, as per the latest revision of Elroy Dimson and company’s widely read reviews of equity risk premia. “Equity Premia Around the World” summarizes the “global evidence on the long-term realized equity risk premium, relative to both bills and bonds, in 19 different countries.” The current paper (dated Oct. 7) is an extension of the data presented in the trio’s 2002 book Triumph of the Optimists: 101 Years of Global Investment Returns. In the new research, the authors report:

Our study now runs from 1900 to the start of 2011. While there is considerable variation across countries, the realized equity risk premium was substantial everywhere. For our 19-country World index, over the entire 111 years, geometric mean real returns were an annualized 5.5%; the equity premium relative to Treasury bills was an annualized 4.5%; and the equity premium relative to long-term government bonds was an annualized 3.8%. The expected equity premium is lower, around 3% to 3½% on an annualized basis.

In a global economy, where political borders have diminishing relevance for capital, estimating equity risk premiums is a complicated affair. The first question for U.S. investors is whether it’s reasonable to consider stocks in a global framework as part of the total analytical package? Yes, of course. That’s not the tradition for those who live in the world’s (still) largest economy, but the home bias for plotting investment strategy as the last word on equity evaluation looks ill-informed with each passing year. Certainly the old excuse that sticking to the home turf is practical is no longer an issue. For example, it’s easy and inexpensive to tap into the global equity beta through various ETFs, such as Vanguard Total World Stock Index ETF (VT) and iShares MSCI ACWI Index (ACWI). The ETF choices are, of course, far more extensive when we look at regional, industry, capitalization and style divisions for global equities. Accordingly, there’s a good case for breaking up a portion of one’s equity allocation to smaller pieces to facilitate rebalancing. Yet the case for a core global equity holding as a foundation isn’t chopped liver either.
In any case, Dimson and his associates at the London Business School offer valuable perspective on where we’ve been over the past century. For example, consider how returns differ with inflation (nominal performance) and without (real returns). The U.S. stock market gained 9.4% a year during the 1900-2010 period, the paper reports, but that drops to an annual 6.3% in real terms. That’s pretty good in comparison to markets around the world, as a chart from the research shows:

The question, of course, is how returns will compare from here on out? Dimson and his co-authors advise that “the historical equity premiums, presented here as annualized (i.e. geometric mean) estimates, are equal to investors’ ex ante expectations plus the impact of luck.” Alas, modeling luck–the error term–is the equivalent of financial alchemy, and so the usual caveats apply when it comes to forecasting generally. That said, the authors press on:

The worldwide historical premium was larger than investors are likely to have anticipated, on account of factors such as unforeseen exchange-rate gains and unanticipated expansion in valuation multiples. In addition, past returns were also enhanced during the second half of the 20th century by business conditions that improved on many dimensions.

With that, we move to the grand finale:

We infer that investors expect a long-run equity premium (relative to bills) of around 3%–3½% on a geometric mean basis and, by implication, an arithmetic mean premium for the world index of approximately 4½%– 5%.

As it turns out, that’s in line with my own number crunching from last month for estimating future risk premiums for stocks (along with the other major asset classes).
None of this is written in stone, of course. Predicting is still hard, especially about the future. In fact, one could argue that it’s not getting any easier these days. They don’t call them risk premiums for nothing.