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Equity Premium

Governments are largely insulated from market forces. Companies are not. Investments in stocks therefore carry substantial risk in comparison with holdings of government bonds, notes or bills. The marketplace presumably rewards risk with extra return. How much of a return premium should investors in equities expect? These blog entries examine the equity risk premium as a return benchmark for equity investors.

The Belief Component of Risk Premiums

Is risk premium variation principally a consequence of changes in objective business conditions, or is some human dynamic important? In their November 2007 paper entitled “Diverse Beliefs and Time Variability of Risk Premia”, Mordecai Kurz and Maurizio Motolese examine the effect of diverse but individually rational market beliefs on risk premiums. They define belief as a variable independent of all observed fundamentals, with its own dynamic that reflects changes in the distribution of investor risk perceptions. Using monthly interest rate forecasts compiled by Blue Chip Financial Forecasts since 1983 to measure market beliefs and associated actual interest rate data, they conclude that: Keep Reading

Calibrating Ancient History

Is there a way to deal with structural breaks more precisely than just expressing vague skepticism about the usefulness of old data? In the April 2007 draft of their paper entitled “How Useful Are Historical Data for Forecasting the Long-run Equity Return Distribution?”, John Maheu and Thomas McCurdy describe and test a methodology for identifying and calibrating structural breaks in long-term excess equity returns. Using monthly U.S. equity return and risk-free rate data for the period February 1885 through December 2003, they conclude that: Keep Reading

The Professor’s Forecast for the Indefinite Future…

…looks something like this: Keep Reading

Honing in on the Prospective U.S. Equity Risk Premium

What is the latest from academia regarding the prospective equity risk premium? In their November 2006 paper entitled “Estimating the Ex Ante Equity Premium”, Glen Donaldson, Mark Kamstra and Lisa Kramer apply new simulation techniques across ten distinct models to calculate what they claim “is by far the most precise equity premium estimate that has been reported in the literature to date.” Using U.S. dividend growth rates, interest rates, Sharpe ratios, price-dividend ratios, return volatilities and the historical equity premium for 1952-2004 to calibrate their simulations, they conclude that: Keep Reading

An Equity Risk Premium Opus

What excess return have you gotten, do you expect, should you require, does the market imply for taking the risk of owning stocks? In his September 2006 paper entitled “Equity Premium: Historical, Expected, Required and Implied”, Pablo Fernandez addresses all these questions in a comprehensive overview/history and analysis of the equity risk premium in the U.S. and other countries. He begins with definitions of four perspectives on the equity premium, the first equal for all investors and the other three varying among investors: Keep Reading

Worldwide Equity Returns in the 21st Century

In his June 2006 article entitled “Investing in the 21st Century: With Occam’s Razor and Bogle’s Wit”, Javier Estrada evaluates the long-term forecasting abilities of two simple models over 10-year periods during 1973-2005. He then uses them to predict the returns for 12 country stock markets (Australia, Belgium, Canada, Denmark, France, Germany, Ireland, Japan, Netherlands, Switzerland, UK, USA) for 2006-2015. He finds that: Keep Reading

Classic Research: Stock Returns in the Long Run

We have selected for retrospective review a few all-time “best selling” research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the March 2002 paper entitled “Stock Market Returns in the Long Run: Participating in the Real Economy” (download count over 3,400) by Roger Ibbotson and Peng Chen. The authors examine the relationships during 1926-2000 between historical equity returns and key supply side factors such as inflation, earnings, dividends, price-to-earnings ratio (P/E), dividend payout ratio, book value, return on equity and GDP per capita. They extrapolate these supply side connections with the real economy to estimate the future long-term equity risk premium. They conclude that: Keep Reading

4% Solution: Equity Risk Premium Update

In their May 2005 paper entitled “The Market Equity Risk Premium”, Brian McCulloch and Dasha Leonova present a comprehensive review of equity risk premium research to support decision-making regarding the annual capital contribution to New Zealand Superannuation Fund, a government-managed pension fund. They seek the best estimate of the future annual premium of nominal long-term equity returns over nominal long-term bond returns. Based on international experiences and forecasts over many decades, they conclude that: Keep Reading

The Best Benchmarkers, Ever!

In their April 2005 draft of “History and the Equity Risk Premium”, two pioneers in the definition and measurement of the equity risk premium, William Goetzmann and Roger Ibbotson, recount the history of this essential benchmark for stock investment returns. Then, they update their estimate of its value for U.S. equities over the past two centuries. Their conclusions are: Keep Reading

Triumph of the Optimists (Chapter-by-Chapter Review)

Triumph of the Optimists: 101 Years of Global Investment Returns by Dimson, Marsh and Staunton (2002) is thorough, logical and concise. With scores of illustrative graphs and figures, its statistics are accessible and its style straightforward. Its message, however, is somewhat at odds with the title. Below is a chapter-by-chapter review of the insights in this book: Keep Reading

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