Does the equity risk premium justify the risk?


B

beliavsky

A survey of professional investors in the U.S.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=959703 found that
their average estimate of the equity risk premium (ERP) over 10-year
Treasury bonds was about 3.5% a year . One-year implied volatility for
the S&P 500 is about 25%, and one-month implied volatility is about
28% (as measured by VIX). Risking about 20% a year to earn 3.5% seems
like insufficient reward for risk to me.

The question is whether expected returns are higher when volatility is
above average, as it is now. It's also possible that the 3.5% ERP
estimate is too low, although many academics have come to similar
conclusions. If nominal GDP rises at say 6% a year, (3% nominal, 3%
real) and dividend yields stay at 2% it's tough to envision stocks
returns being 12% a year, implying 10% annual price appreciation,
since then the ratio of stock market capitalization to GDP would
increase without bound.

As a financial professional I am forced to follow the markets daily,
and seeing one's net worth bounce around by 1 to 2% a day for a 3.5%
annual reward is even more unpleasant. OK, partly I'm just grumbling
about the recent market action, but I think it would be interesting to
see how suggested asset allocations for an investor depend on
one's estimates for stock market volatility and return.

Stock market volatility is especially painful because stock returns
tend to be worse in "bad" states of the world, for example states with
soaring commodity prices, collapsing banks, and rising unemployment.

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E

Elizabeth Richardson

Stock market volatility is especially painful because stock returns
tend to be worse in "bad" states of the world, for example states with
soaring commodity prices, collapsing banks, and rising unemployment.
Another bear? Goody, goody. Come on bears, get out in the open, the more of
you, the better. A distinct lop-sidedness of either bears or bulls is a
contrarian indicator. Lots of bears means we're near a bottom, just as when
there are too many bulls, we're near a top.

Elizabeth Richardson

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Misc.invest.financial-plan is a moderated newsgroup where Moderators strive
to keep the conversations on-topic for financial planning. Other posting
guidelines include a request for brevity and another for trimming posts to
which we respond. For all of the other tips and suggestions, see "FROM THE
MODERATORS: Posting to misc.invest.financial-plan", a weekly post now on the
Newsgroup.
 
D

David Moore

I'm not sure how much subjective estimates of the equity risk premium
are worth. Here are my notes on the Dimson et al. study of data for
the entire 20th century:

(The equity risk premium is ...)
Extremely variable annually, roughly normal mean 7.7% std dev 19.6.
Geometric 1900-2000 5.8% over bills. Same ballpark internationally.
Ten-year premia: arithmetic 5.8% with std dev 5.4%, geometric 5.6%.
NOTE lower than most previous studies due to longer time frame.

David

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Misc.invest.financial-plan is a moderated newsgroup where Moderators strive
to keep the conversations on-topic for financial planning. Other posting
guidelines include a request for brevity and another for trimming posts to
which we respond. For all of the other tips and suggestions, see "FROM THE
MODERATORS: Posting to misc.invest.financial-plan", a weekly post now on the
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R

Ron Peterson

A survey of professional investors in the U.S.http://papers.ssrn.com/sol3/papers.cfm?abstract_id=959703found that
their average estimate of the equity risk premium (ERP) over 10-year
Treasury bonds was about 3.5% a year . One-year implied volatility for
the S&P 500 is about 25%, and one-month implied volatility is about
28% (as measured by VIX). Risking about 20% a year to earn 3.5% seems
like insufficient reward for risk to me.
As one who is investment portfolio is heavy in equities, I feel that
volatility.
The question is whether expected returns are higher when volatility is
above average, as it is now. ...
I think that high volatility is being driven by professional investors
managing the different funds and won't be going away without
legislation. Investment returns are driven by how profitable the
companies are and how much is left for the stock holders, not the
volatility of the stock price.
As a financial professional I am forced to follow the markets daily,
and seeing one's net worth bounce around by 1 to 2% a day for a 3.5%
annual reward is even more unpleasant. OK, partly I'm just grumbling
about the recent market action, but I think it would be interesting to
see how suggested asset allocations for an investor depend on
one's estimates for stock market volatility and return.
That 3.5% extra return will result in almost 100% more after 20 years,
so it's a no brainer.
Stock market volatility is especially painful because stock returns
tend to be worse in "bad" states of the world, for example states with
soaring commodity prices, collapsing banks, and rising unemployment.
A person can now invest in most countries of the world through ADRs
and ETFs reducing risk, but not much reduction in volatility.

--
Ron

--------------------------------------
Misc.invest.financial-plan is a moderated newsgroup where Moderators strive
to keep the conversations on-topic for financial planning. Other posting
guidelines include a request for brevity and another for trimming posts to
which we respond. For all of the other tips and suggestions, see "FROM THE
MODERATORS: Posting to misc.invest.financial-plan", a weekly post now on the
Newsgroup.
 

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