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.
But the central challenge is unyielding. Professor Bradford Cornell sums it up this way in The Equity Risk Premium:
…the efficient market hypothesis is a kind of catch-22 of investing. Information that is predictable is worthless because it is already reflected in stock prices. The information that is valuable and can be used to make money is that information which cannot be predicted.
But investors require a risk premium to hold stocks, and history suggests the demand is sated. Not over every period in the short run, or in any given stock or even one stock market. The global equity risk premium, however, tends to be relatively durable, largely because global economic growth is reliably persistent over the long haul.
In fact, risk premia overall are linked the ebb and flow of economic conditions. As Professor John Cochrane explains in a chapter from the Handbook of the Equity Risk Premium:
Some assets offer higher average returns than other assets, or, equivalently, they attract lower prices. These “risk premia” should reflect aggregate, macroeconomic risks; they should reflect the tendency of assets to do badly in bad economic times.
In fact, lots of research tells us, backed up by the historical record, that the equity premium fluctuates. That’s not obvious by looking at the long-term record. Indeed, we know that the S&P 500 has generated a roughly 10% total return since 1926, according to Ibbotson Associates. (We can figure out the equity risk premium from this record by subtracting, say, the 3.7% annualized total return of 3-month T-bills over that span from the equity market gain.)
Yet looking at equity returns in smaller bites, such as 20-year periods, reflects a wider variety of annualized results, ranging from around 8% up to nearly 18%. Unsurprisingly, shorter time frames—five or 10 year rolling periods, for instance—harbor even more volatility in performance results.
Why does the equity risk premium vary? The basic answer is that investors require different risk premiums at different times depending on, well, lots of things. “When buyers demand increased compensation for risk, they pay lower prices, basically demanding that sellers compensate them for the increased risk that they see in owning stock,” writes Pimco’s market strategist Tony Crescenzi in his recent book Investing From the Top Down: A Macro Approach to Capital Markets. “By paying lower prices for stocks, buyers exact a ‘premium’ from the sellers of stock. Conversely,
when investors are risk-averse, they demand a smaller amount of compensation for the risks they see. This means that they become willing to pay higher prices, believing that equities carry relatively less risk than before. This happened in 1999 and 2000 when stock prices soared, with investors perceiving very little risk in owning stocks, a belief that was way off the mark.
The perennial challenge, of course, is developing some reasonable intuition about the period ahead. We can begin by considering the historical equity risk premium. This is naïve, of course, but it offers a reasonable benchmark as a starting point. But looking to the long-run past as the definitive guide to what’s in store over, say, the next 10 or even 20 years may be courting trouble.
How can we modify the historical risk premium to reflect something more realistic given the current conditions? There are no quick or fool-proof answers. In fact, we should look to a range of methodologies for some perspective. A full treatment is far beyond the scope here, but we might start by considering the Gordon growth model. Very briefly, quite a bit of academic study demonstrates that dividend yields and expected equity returns share a relationship, as our chart below shows. And if we consider current yield in context with its historical record of increase, we’re beginning to scratch up some useful information.
If we take the current yield on the stock market (~1.7% at the end of Feb. 2010, according to Standard & Poor’s) and add that to the growth rate of dividends over the past 60 years—roughly 5%—we have an expected total return for U.S. stocks of 6.7%, or below the 9%-to-10% historical total return since 1926.
This is hardly the last word on looking ahead, but it’s a reasonable way to begin. But investors need to consider other factors as well. Academic research can be helpful in making forecasts. It’s no panacea, but the context is productive. But it’s only the beginning. In fact, forecasting the equity risk premium is an ongoing chore, and one that requires continual reassessement, research and reflection.
With that in mind, here are some recent studies on the equity risk premium that are worth a look. Think of it as a taking a few more steps forward on the thousand-mile journey of prediction.
Out-of-Sample Equity Premium Prediction: Economic Fundamentals vs. Moving-Average Rules
by Christopher J. Neely, David E. Rapach, Jun Tu, and Guofu Zhou
This paper analyzes the ability of both economic variables and moving-average rules to forecast the monthly U.S. equity premium using out-of-sample tests for 1960–2008. Both approaches provide statistically and economically significant out-of-sample forecasting gains, which are concentrated in U.S. business-cycle recessions. Nevertheless, economic variables and moving-average rules capture different sources of equity premium fluctuations: moving average rules detect the decline in the average equity premium early in recessions, while economic variables more readily pick up the rise in the average equity premium later in recessions. When we simulate data with a habit-formation model characterized by time-varying return volatility and risk aversion relating to business-cycle fluctuations, we find that this model cannot fully account for the out-of-sample forecasting gains in the actual data evidenced by economic variables and moving-average rules.
Equity Risk Premiums (ERP): Determinants, Estimation and Implications—The 2010 Edition
By Aswath Damodaran
New York University – Department of Finance
Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. We begin this paper by looking at the economic determinants of equity risk premiums, including investor risk aversion, information uncertainty and perceptions of macroeconomic risk. In the standard approach to estimating equity risk premiums, historical returns are used, with the difference in annual returns on stocks versus bonds over a long time period comprising the expected risk premium. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to be limited and volatile. We look at two other approaches to estimating equity risk premiums – the survey approach, where investors and managers are asked to assess the risk premium and the implied approach, where a forward-looking estimate of the premium is estimated using either current equity prices or risk premiums in non-equity markets. We also look at the relationship between the equity risk premium and risk premiums in the bond market (default spreads) and in real estate (cap rates) and how that relationship can be mined to generated expected equity risk premiums. We close the paper by examining why different approaches yield different values for the equity risk premium, and how to choose the “right” number to use in analysis.
The Equity Premium in 150 Textbooks
By Pablo Fernández
I review 150 textbooks on corporate finance and valuation published between 1979 and 2009 by authors such as Brealey, Myers, Copeland, Damodaran, Merton, Ross, Bruner, Bodie, Penman, Arzac… and find that their recommendations regarding the equity premium range from 3% to 10%, and that 51 books use different equity premia in various pages. The 5-year moving average has declined from 8.4% in 1990 to 5.7% in 2008 and 2009. Some confusion arises from not distinguishing among the four concepts that the phrase equity premium designates: the Historical, the Expected, the Required and the Implied equity premium. 129 of the books identify Expected and Required equity premium and 82 identify Expected and Historical equity premium. Finance textbooks should clarify the equity premium by incorporating distinguishing definitions of the four different concepts and conveying a clearer message about their sensible magnitudes.