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Equity Risk Premium and Investment Horizon

February 2, 2018 • Posted in Equity Premium

How should an investor’s view of the equity risk premium vary with investment horizon? In the December 2017 update of their paper entitled “Volatility Lessons”, Eugene Fama and Kenneth French examine how the U.S. equity risk premium (difference in returns between the expected equity market return over some horizon and return on U.S. Treasury instrument of matched duration) varies across investment horizons ranging from one month to 30 years. To generate distributions of equity risk premiums for horizons longer than one month, they employ bootstrap simulations. Specifically, for each matched horizon/duration, they randomly draw 100,000 pairs of stock market and U.S. Treasury instrument returns with replacement from a base sample of monthly data, without or with an adjustment for uncertainty in associated equity premiums. They repeat analyses on three value portfolios (Market Value, Big Value and Small Value) and on a Small stock portfolio with no value tilt, defining size and value as follows: (1) big (small) stocks are U.S. listed stocks with market capitalizations above (below) the NYSE median; and, (2) value stocks are U.S. listed stocks with book-to-market ratios above the 70th percentile of those for NYSE stocks. All style portfolios are capitalization-weighted and rebalanced annually at the end of June. Using monthly U.S. stock returns and and U.S. Treasury instrument yields across durations during July 1963 through December 2016 (642 months), they find that: (more…)

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