equity risk premium

The Joys of Compounding: The Passionate Pursuit of Lifelong Learning, Revised and Updated

by Gautam Baid  · 1 Jun 2020  · 1,239pp  · 163,625 words

what you are doing. In fact, Buffett considers this to be one of the biggest risks in investing. So much so that he avoids using equity risk premiums to value stocks, confining himself only to those situations about which he is highly certain. Buffett uses the interest rate of long-term U.S

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a result, many investors end up engaging in “hyperbolic discounting,” heavily discounting the distant but large cash flows of high-quality businesses by applying high equity risk premiums, and they end up with much lower estimates of intrinsic business value than otherwise would have been the case. Consequently, even though those businesses may

Smarter Investing

by Tim Hale  · 2 Sep 2014  · 332pp  · 81,289 words

machine. This longer-term return for taking on the voting machine risks of being an owner, above the risk-free rate, is known as the equity risk premium (see Figure 6.4). Smaller company (size) and value risks The Fama and French research referred to above, breaks down the risk that an investor

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key components: Equity market risk: being in the equity market as a whole, as opposed to simply holding ‘safe’ cash, for which you receive the equity risk premium, or ERP for short. Size risk: which is the risk of owning more risky smaller companies rather than larger companies, for which you would expect

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creditors; this more risky position (i.e. the higher cost of capital) demands greater reward for investors. This reward or premium is known as the equity risk premium. Measuring it in the past is simple enough; however, like many arguments in investing, not only are there short-term exceptions to long-run averages

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, but also different time frames tell different stories. Academics and economists argue ad infinitum about the level of the equity risk premium but as the Economist succinctly put it in 2003: ‘Yes, over long periods equities have done better than bonds. But there is no equity “premium

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their own view Other voices in the industry have different opinions. In the case of Dimson, Marsh and Staunton (Dimson et al., 2013), the future equity risk premium above cash is expected to be lower at around 3.0% to 3.5%. JP Morgan Asset Management (my alma mater) on the other hand

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estimates that the equity risk premium for developed markets is pretty close to long-term history at around 5% (JP Morgan, 2012). No one knows for sure. Perhaps model 5% and

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fall near equities, given its hybrid asset status and the fact that leverage is inherent in the REIT structure. Depending on your view of the equity risk premium for developed markets, REITs could be expected to deliver performance around 1% below equities. Table 11.7 Global REIT drawdowns > 10% from 1987–2012 Downside

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-sum investments in and market timing, 2nd, 3rd risk, 2nd, 3rd stock selection UK active funds equity markets developed diversifiers, 2nd risk, 2nd volatility of equity risk premium equity-oriented assets ETFs (Exchange Traded Funds), 2nd, 3rd, 4th, 5th and DIY investors, 2nd, 3rd, 4th taxes and inflation-linked bonds providers, 2nd eye

The Long Good Buy: Analysing Cycles in Markets

by Peter Oppenheimer  · 3 May 2020  · 333pp  · 76,990 words

the Cycle under Very Different Conditions Notes Chapter 2: Returns over the Long Run Returns over Different Holding Periods The Reward for Risk and the Equity Risk Premium The Power of Dividends Factors That Affect Returns for Investors The Impact of Diversification on the Cycle Notes Chapter 3: The Equities Cycle: Identifying the

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suggests that we are in a particularly unusual environment for picking assets, a topic dealt with in chapter 9. The Reward for Risk and the Equity Risk Premium Comparing returns on bonds and equities enables us to look retrospectively at the reward for taking risk (investing in the unknown future return on equities

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investments, but so too are the upside potential returns. The achieved return in equities compared with bonds is often referred to as the ex post equity risk premium (ERP), or the actual reward over time that investors achieve by investing in equities relative to safe government bonds. This is different from the required

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equity risk premium, which is more a measure of likely relative future returns, or the expected premium of risk assets versus safe assets that an investor would require

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the rate of return on government bonds was just below 1%. Subtracting the return on bonds from the return on stocks left a so-called equity risk premium of over 6% per year, which could only be explained by a high degree of risk aversion. They went on to argue that other trade

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areas of financial behaviour are much lower, consistent with an ERP of 1% or less. They called this conundrum the equity risk premium puzzle. Since then, much of the research has found that the equity risk premium has varied over time. Bernstein (1997), for example, suggested that because equity valuations have changed over time, this could

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the work of Fama and French (2002), which used a discounted dividend model (the DDM) to show that investors from 1926 onwards had an expected equity risk premium that averaged about 3%. Others have emphasised that spot valuations can also distort the expectations for returns. In particular, Robert Shiller in his book Irrational

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this visibility caps the potential downside risk. Investors respond to the lower tail risk by increasingly accepting lower future expected returns (and higher valuations); the equity risk premium declines and valuations rise as the ‘fear of missing out’ often drives investor sentiment. Although volatility is still high, it tends to fall towards the

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the early 1980s (as explained previously) was driven by the combination of falling inflation expectations and interest rates, together with a meaningful decline in the equity risk premium, which triggered substantial P/E multiples expansion. This increase in valuations was marked and prompted by significant shifts downwards in bond yields and central bank

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the technology bubble in the late 1990s. In his speech to the ASPF, Ross Goobey presented the long-run historical evidence that the ex post equity risk premium (the return investors achieved in equities versus bonds) was positive in real terms, and that investors ignored this at their own peril. The long-run

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a war, oil price shock, EM crisis or technical market dislocation), but which leads to a short-lived rise in uncertainty and pushes up the equity risk premium (the required rate of return). Structural bear. Usually triggered by the unwinding of structural imbalances and financial bubbles. Often a price shock, such as deflation

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is at least possible in retrospect to see some sharp falls in equity markets as a consequence of a one-off rise in the required equity risk premium as a result of an event. Because these events in many cases did not result in a shift in the economic cycle or the underlying

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to strong returns in the equity markets in this period, valuations also recovered from their post-war levels aided by a secular decline in the equity risk premium as many of the risks to the global system faded. New international institutions and a rule-based global trading system emerged.1 The setting up

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interest rates stay low as a result of the purging of global high inflation but also the end of the Cold War helped push the equity risk premium down further (the required hurdle rate for investing in risky assets compared with low-risk bonds). This strong secular bull market was buffeted once again

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: Goldman Sachs Global Investment Research. This term premium exists because investors need to be compensated for bearing economic risks (just as with equities and the equity risk premium). For bond holders there are two particularly relevant risks. One is inflation: unexpected inflation erodes the real value of fixed nominal payments, reducing real returns

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]) SOURCE: Goldman Sachs Global Investment Research. Zero Rates and Growth Expectations The comparison between the yield on government bonds and equities can approximate for the equity risk premium, or the required return that investors have in equities relative to bonds. This can be affected by uncertainty and by changes in investors' long-term

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market is fairly priced on the basis that investors expect zero earnings and dividend growth into perpetuity. At the other end of the spectrum, the equity risk premium would need to be 8% for the market to be expecting long-term nominal earnings growth of 4.7% (roughly 2.7% real earnings growth

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do not necessarily benefit equities. In general, the experience from Japan and Europe in particular suggests that lower bond yields have pushed up the required equity risk premium – the extra return that investors demand for taking risk and buying equities relative to risk-free government bonds. Zero or negative bond yields can affect

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do not necessarily benefit equities. In general, the experience from Japan and Europe in particular suggests that lower bond yields have pushed up the required equity risk premium – the extra return that investors actually demand for taking risk and buying equities relative to risk free government bonds. Zero or negative bond yields can

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. Siegel, J. J. (1992). The equity premium: Stock and bond returns since 1802. Financial Analysts Journal, (48)1, 28–38. Siegel, L. B. (2017). The equity risk premium: A contextual literature review. CFA Research Foundation Literature Reviews, 12(1). Spierdijk, L., Bikker, J., and van der Hoek, P. (2010). Mean reversion in international

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: Channels and implications for policy. Brookings Papers on Economic Activity, pp. 215–265. Wright, I., Mueller-Glissmann, C., Oppenheimer, P., and Rizzi, A. (2017). The equity risk premium when growth meets rates. London, UK: Goldman Sachs Global Investment Research. Wright, J. H. (2012). What does monetary policy do to long-term interest rates

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-2007 57 current 57–58, 76–79 historical periods 56–58 length 49 mini/high-frequency 58–61 phases 50–56 structural shifts 76–79 equity risk premium (ERP) 35–38, 69–72, 210 ERM see exchange rate mechanism ERP see equ ity risk premium ESM see European stability mechanism Europe dividends 39

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. 155–156 volatility 30–31 bear markets 104–105, 107, 115 current equity cycle 187–189 cyclical bear markets 105, 107 diversification 42, 42–47 equity risk premium 35–38 holding periods 31–34 market timing 41–43 structural bear markets 105, 115 Volker, P. 102, 131 W wages 185, 238–239 watchmakers

Capital Ideas Evolving

by Peter L. Bernstein  · 3 May 2007

in which your return will be less than zero, and who wants that? So if we can’t expect to get empirical proof of the equity risk premium in an experimental setting, I don’t think fiduciaries should keep throwing that basic premise of stocks as a sure thing over the long run

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Less risk-free rate 6.50% −1.50% REIT risk premium over cash Less REIT beta × Equity risk premium at 5.75% = 0.4833 × 0.0575 = 5.00% −2.78% Passive REIT alpha * 2.22% The equity risk premium of 5.75 percent in this example is derived in Exhibit 1 on page 2 of Leibowitz

More Than You Know: Finding Financial Wisdom in Unconventional Places (Updated and Expanded)

by Michael J. Mauboussin  · 1 Jan 2006  · 348pp  · 83,490 words

Shot Streaks and Skill Toss Out the Coin Toss Streaks and Luck Chapter 8 - Time Is on My Side One or One Hundred Explaining the Equity-Risk Premium The Value of Inactivity Pictures Worth a Thousand Words Chapter 9 - The Low Down on the Top Brass Management Counts Leadership Incentives Capital Allocation The

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(or portfolio) rising and the investment-evaluation period become paramount. I want to shine a light on the policies regarding these two variables. Explaining the Equity-Risk Premium One of finance’s big puzzles is why equity returns have been so much higher than fixed-income returns over time, given the respective risk

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developed countries around the world have seen similar results.4 In a trailblazing 1995 paper, Shlomo Benartzi and Richard Thaler suggested a solution to the equity risk premium puzzle based on what they called “myopic loss aversion.” Their argument rests on two conceptual pillars:5 1. Loss aversion. We regret losses two to

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a return and, hence, a positive utility. Benartzi and Thaler, using a number of simulation approaches, estimate that the evaluation period consistent with the realized equity-risk premium is about one year. It is important to note that the evaluation period is not the same as the investor’s planning horizon. An investor

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. This fallacy of composition is the flaw behind the “Dow 36,000” theory, which argues that if all investors adopt a long-term horizon, the equity-risk premium will dissipate and the market will enjoy a onetime rise.9 Changing the nature of the investors changes the nature of the market. If all

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populations that are different—the data are said to be nonstationary. When data are nonstationary, projecting past averages typically produces nonsensical results. —Bradford Cornell, The Equity Risk Premium Intangible assets . . . surpass physical assets in most business enterprises, both in value and contribution to growth, yet they are routinely expensed in the financial reports

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big drivers of price-earnings ratio nonstationarity are the role of taxes and inflation; changes in the composition of the economy; and shifts in the equity-risk premium. Why the Past May Not Be Prologue A bedrock concept in finance is that investors price assets to generate an appropriate return (adjusted by perceived

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capital support higher price-earnings ratios.4 The final factor that dictates the price-earnings ratio is the equity-risk premium, or the return that equity investors demand above and beyond a risk-free security. (The equity-risk premium itself appears to be nonstationary.) 5 While a number of factors come into play to determine the

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risk premium, including future growth estimates, the aggregate risk appetite of investors is certainly important. In periods of general optimism, equity-risk premiums shrink, and premiums expand when investors are cautious. The ebb and flow of investor risk appetite likely contributes to the nonstationarity of multiples. Bounded Parameters

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which the market reverts? The answer, I believe, is a qualified no. In all likelihood, two of the three drivers of nonstationarity—taxes/inflation and equity risk premium—are probably bounded. That is, they vacillate within reasonably defined, albeit large, channels. These drivers might average out over the very long term (i.e

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Individual Stock Returns,” Journal of Finance 56, no. 4 (August 2001): 1247-92. 4 Elroy Dimson, Paul Marsh, and Mike Staunton, “Global Evidence on the Equity Risk Premium,” Journal of Applied Corporate Finance 15, no. 4 (Fall 2003): 27-38. 5 Benartzi and Thaler, “Myopic Loss Aversion.” 6 This and following exhibits closely

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.socialsecurity.gov/history/hfaq.html. 2 Richard Roll, “Rational Infinitely-Lived Asset Prices Must be Non-Stationary,” Working Paper, November 1, 2000; Bradford Cornell, The Equity Risk Premium: The Long-Run Future of the Stock Market (New York: Wiley, 1999), 45-55; Eugene F. Fama and Kenneth R. French, “The Equity Premium,” Journal

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, no. 1 (Fall 2000): 72-81. 4 Alfred Rappaport, “How to Avoid the P/E Trap,” Wall Street Journal, March 10, 2003. 5 Cornell, The Equity Risk Premium, 59. 6 See http://www.econ.yale.edu/~shiller/. 25. I’ve Fallen and I Can’t Get Up 1 Lakonishok, quoted in Mark Hulbert

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. Why Big Fierce Animals Are Rare. Princeton, N.J.: Princeton University Press, 1978. Collins, Jim. Good to Great. New York: HarperBusiness, 2001. Cornell, Bradford. The Equity Risk Premium: The Long-Run Future of the Stock Market. New York: Wiley, 1999. Corporate Strategy Board. “Stall Points: Barriers to Growth for the Large Corporate Enterprise

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, 1998. Dickinson, Rod. “The Milgram Reenactment.” http://www.milgramreenactment.org/pages/section.xml?location51. Dimson, Elroy, Paul Marsh, and Mike Staunton. “Global Evidence on the Equity Risk Premium.” Journal of Applied Corporate Finance 15, no. 4 (Fall 2003): 27-38. Dugatkin, Lee Alan. The Imitation Factor: Evolution Beyond the Gene. New York: Free

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solving 80/20 rule Eisenhardt, Kathy El Farol bar example Ellis, Charles Elton, Charles emotions engineered systems Enriquez, Juan Enron enterprise Epstein, Richard equity funds equity-risk premium evaluation, frequency of evolution: average speed of; of brain; fitness landscapes and; of investors exit rules expectations; deductive and inductive processes; extrapolative; leader/ challenger dynamics

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for strategies for winners strategy as simple rules Long Term Capital Management long-term investment, loss aversion and Lorie, James loss, risk and loss aversion equity-risk premium exhibits myopic portfolio turnover ratio of risk to reward utility lottery players Lowenstein, Roger luck MacGregor, Donald G. MacKay, Charles Malkiel, Burton Mandelbrot, Benoit B

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Raup, David Raynor, Michael E. reciprocity recombination reductionism reflexivity requests, compliance with return on investment CFROI distribution of equity-risk premium growth and reversion to cost of capital total returns to shareholder (TRS) risk equity-risk premium explanation for risk-reward relationship rival and nonrival goods Rogers, Jim Roll, Richard Roman alphabet Romer, Paul roulette Rubin

Triumph of the Optimists: 101 Years of Global Investment Returns

by Elroy Dimson, Paul Marsh and Mike Staunton  · 3 Feb 2002  · 353pp  · 148,895 words

of 2000–01, it is necessary to justify the relatively high rating of today’s stock markets in terms of a historically low forward-looking equity risk premium. For the investment strategist this raises the most fundamental question of all: Do investors realize that returns are likely to revert to more normal

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index construction (for the United Kingdom), and (for both countries) from the use of a rather longer time frame, extending back to 1900. The equity risk premium is a very important economic variable. An estimate of the premium is central to projecting future investment returns, calculating the cost of equity capital, valuing

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of the investment implications of our findings. We emphasize how we should alter our judgments in the light of a reduced estimate for the future equity risk premium. There are strong inferences that can be drawn about the role for active management, the case for index funds, levels of management fees, tax

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years of the last century was much less than many had previously assumed. This suggests that we should now revise downward our estimates of the equity risk premium (see chapter 13). Finally, we highlight the prevalence and dangers of easy data bias. This refers to the tendency of researchers to use data

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chapter 5. Interestingly, inflation appears to have had a negative impact on both stock and bond markets. This means that when we later consider the equity risk premium relative to bonds (see section 12.3), we may find the risk premium less affected by inflation than the underlying equity and bond returns.

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, however, is not the appropriate benchmark since US investors have earned positive real returns from much lower risk investments in bills and bonds. The equity risk premium relative to bills and bonds forms the topic of chapter 12. The standard deviation of real returns on US equities was 20.2 percent. If

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nominal terms. Bond returns are not only important in their own right, but also because they are often used as a benchmark in computing the equity risk premium. But while government bonds are generally default free, they are not “risk free.” For although investors know for sure how many dollars they will

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receive in the future, they do not know their purchasing power. Despite this, we follow common practice when we calculate the equity risk premium relative to bonds as well as bills (for example, in chapter 12). This premium is clearly of interest— whether viewed as a true risk

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research which focus on dividends, dividend growth, and yields, we now need to consider total payout as well as cash dividends. Chapter 12 The equity risk premium Investment in equities over the 101 years from 1900–2000 has proved rewarding but, as we have seen, has been accompanied by correspondingly greater risks

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in the past by comparing the return on equities with the return from risk free investments. The difference between these two returns is called the equity risk premium. The risk premium is typically measured relative to either government bills or bonds. In sections 12.1 and 12.2 we therefore analyze the

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examine the risk premium relative to long bonds. In each case, we look first at the United States, and then at worldwide comparisons. The equity risk premium is an extremely important economic variable. An estimate of the premium is central to projecting future investment returns, calculating the cost of equity capital for

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the risk premium. 12.1 US risk premia relative to bills To establish whether equity risk has been adequately rewarded, we need to measure the equity risk premium. This is typically calculated in one of two ways. The first uses treasury bills (very short-term, default-free, fixed-income government securities) as

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another and the result (11 percent) would be similar. These measures of the risk premium have no obvious numeraire in terms of currency since the equity risk premium, measured relative to bill or bond returns, is a ratio. It is hence unaffected by whether returns are computed in dollars or (say) pounds,

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On average, therefore, US investors received a positive—and quite large—reward for exposure to equity market risk. Figure 12-1: Histogram of US equity risk premium relative to treasury bills, 1900–2000 201902 1948 1911 1978 1912 1939 1947 1916 1934 1921 1992 1956 1926 1982 1993 1968 1986 1959 15

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the United States in all but four of the other countries. Table 12-1: Worldwide equity risk premia relative to bills, 1900–2000 Annual equity risk premium relative to treasury bills Geometric Arithmetic Standard Standard Minimum Maximum Country mean mean error deviation return Australia 7.1 8.5 1.7 17.2

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prices are sensitive both to changes in real interest rates and to inflationary expectations. Since bonds are riskier than bills, we would expect the equity risk premium relative to bonds to be lower than the premium relative to bills. Long-term bonds do have one advantage as a benchmark in that their

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. First, our evidence does not fully support Jorion and Goetzmann’s (1999) claim that "the high equity premium obtained for US Chapter 12 The equity risk premium 175 [and, by implication, UK] equities appears to be the exception rather than the rule." While the United States and the United Kingdom have indeed

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. In our concluding observations, in section 13.8, we summarize what we can learn from the historical record as an indicator of the future equity risk premium around the world. 13.1 Why the risk premium matters Investors do not knowingly take on risk unless there is some expected recompense for their

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risk exposure. For taking on the risks of the equity market, this compensation takes the form of the equity risk premium. Why is it that the size of the equity premium has attracted so much attention? Perhaps the most straightforward answer is that the risk

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optimists are correct; and if it is large, the Shiller pessimists are correct. This is why most finance professionals and financial economists regard the equity risk premium as the single most important number in finance. To measure the equity market premium and to establish the reward for risk, we need to look

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expected future arithmetic risk premia, conditional on current predictions for market volatility. It is not clear how investors should ideally adjust historical estimates of the equity risk premium to reflect today’s judgments about stock market volatility. The approach we follow is to recalculate the arithmetic means, assuming current projections of early

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the arithmetic mean premia? These premia, measured relative to treasury bills, are represented graphically by the line-plot in Figure 13-2. The US equity risk premium is estimated at 7.1 percent, and that for the United Kingdom is 6.0 percent. Arithmetic mean Chapter 13 The prospective risk premium 185

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premia, including Brealey and Myers (2000) and Bodie, Kane and Marcus (1999). Until recently, it was widely believed that the best predictor of the equity risk premium was its own past average. Certainly, researchers such as Goyal and Welch (1999) are unable to find variables that robustly predict the equity premium better

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in fact, extrapolate from the historical record into the future. Welch studies the opinions of 226 financial economists who were asked to forecast the arithmetic equity risk premium in the United States. His findings are summarized in Figure 13-3, which shows that the mean forecast of the arithmetic thirty-year equity premium

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anchored in long-run historical data, the Welch survey respondents might now wish to make a corresponding further downward revision in their forecasts of the equity risk premium. Welch (2001) is now updating his survey. If his new respondents were to make a full 1.1 percent reduction in their mean, the

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section 13.3, even with 101 years of data, standard errors remain high and our estimates of the average are imprecise. Second, the expected equity risk premium could change over time. This might be because the underlying risk of equity investment has fluctuated, particularly as the variety of exchange-listed sectors has

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our dividend projections are simplistic, and the reader should not put too much weight on cross-country differences. The key point is that the expected equity risk premium, based on the last century, should be lower than our backward-looking, historical averages suggest. Our estimates indicate a geometric mean premium for the

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arithmetic risk premium for the world index is 4.0 percent. In fact, whichever country one focuses on, our forward-looking predictions for the equity risk premium are lower than the historically based projections reviewed in section 13.4. There is scope to finesse our estimates of the expected risk premium. Some

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task for future researchers. Finally, note that the use of historical averages as indicators of current required returns suggests that France may have a higher equity risk premium, while Denmark’s risk premium may be lower (see Figure 13-2). There are obviously differences in risk between markets, but this is unlikely

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Survey evidence on best practice by corporations and financial advisors, such as Bruner, Eades, Harris, and Higgins (1998), reveals that nearly all respondents estimate the equity risk premium by averaging past data. However, there is considerable variation in their choice of time period and in their method of averaging, whether arithmetic or geometric

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might be expected in the future. 194 Triumph of the Optimists: 101 Years of Global Investment Returns The chapter addresses four questions: Which historical equity risk premium should one use as the starting point? Why has it typically been so high? What is a good forward-looking predictor for the future? How

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range of premia that 195 Triumph of the Optimists: 101 Years of Global Investment Returns 196 Figure 14-1: Annualized US equity risk premium over periods of up to 101 years Annualized equity risk premium relative to bills (%) 40 Maximum Median Minimum 30 20 Top decile Bottom decile To date 10 5.8 0 -10 -

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further, as a successively larger number of years is used in the calculations. Eventually, at the right-hand side of Figure 14-1, the equity risk premium is the annualized figure over the entire period 1900–2000. This reports the investment experience of a (now rather elderly) investor who bought stocks at

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provided favorable conditions for long-term equity portfolios. Figure 14-2 presents an analysis for the Figure 14-2: Annualized UK equity risk premium over periods of up to 101 years Annualized equity risk premium relative to bills (%) 18 Maximum Median Minimum 12 Top decile Bottom decile To date 6 4.8 0 -6 10

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distribution of the Dutch Triumph of the Optimists: 101 Years of Global Investment Returns 200 Figure 14-3: Annualized Dutch equity risk premium over periods of up to 101 years 16 Annualized equity risk premium relative to bills (%) Maximum Median Minimum 12 Top decile Bottom decile To date 8 5.1 4 0 -4 -8

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in this book. Today’s real interest rates and bond yields are, of course, much higher than the twentieth century average. Compared to the equity risk premium from recent decades, today’s forward-looking equity premium is lower. This changing balance in expected rewards has significant implications for individual investors. It highlights

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they benefit from their prospective gains from stock selection. At the same time, they suffer the extra risk of an imperfectly diversified portfolio. If the equity risk premium is believed to be large, it is less attractive to bet heavily on stocks that appear mispriced. It is preferable to control bets, and to

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than was previously thought. For skilled investors, the size of their portfolio bets should therefore be larger. Our evidence on the small magnitude of the equity risk premium provides encouragement for active investors to deviate more from benchmark, and to take on more active risk. Active investors are often interested in anomalies and

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, relative to the average. In other asset pricing models, systematic risk has a somewhat different connotation. But whichever model is used, the size of the equity risk premium will, explicitly or implicitly, play a central role. Corporate executives regularly review new projects, investments, acquisitions, and divestments, and assess whether existing businesses are

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are excessive, they are likely to reject potentially worthwhile projects that should, in fact, be accepted. We have documented a fall in the expected equity risk premium that captures what we believe is really happening in financial markets. If that opinion is accepted, it is probable that some companies will run the

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cost of capital, while stressing the scope for more research in this area. As well as being a major factor for investors and managers, the equity risk premium is of fundamental importance to regulators. To company managers, the cost of capital is central to Chapter 15 Implications for companies 217 setting minimum

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unfairly high return. The benchmark for judging whether returns are excessive should be the company’s cost of capital, which in turn depends on the equity risk premium. We have seen that the historical risk premium impounds the favorable experiences of the past: the fact that history, at least over recent decades,

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estimating risk premia from the global record, and not simply from the history of individual countries. Third, our new (and lower) estimates of the equity risk premium are of direct relevance to regulators. Finally, our research informs strategy for pension plan sponsors. 15.3 Corporate financing decisions Since our research relates to

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between stock market performance and underlying dividend and GDP growth. But the single most important variable that we document in this book is surely the equity risk premium. High and volatile levels for the stock market fuelled debate about the expected level of the risk premium, since this is central to the

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last 101 years. If instead required returns rise, then share prices will fall, and equities will underperform. Perversely, only if we accept that the expected equity risk premium is now at a permanently low level can high stock prices be justified. 16.3 Conclusion “An optimist,” observed Archy the cockroach, “is a

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productivity and efficiency, improvements in management and corporate governance, and extensive technological change. Corporate cash flows grew faster than expected, and in all likelihood the equity risk premium fell, further boosting stock prices. In short, it was the triumph of the optimists. Statistical logic tells us that future expectations must lie below

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Finance 8: 95–102 Conant, C.A., 1908, The world's wealth in negotiable securities. Atlantic Monthly 101(1): 97– 104 Cornell, B., 1999, The Equity Risk Premium. NY: Wiley Cowles, A., and Associates, 1938, Common Stock Indexes, first edition. Bloomington, Indiana: Principia Press, Inc. Credit Suisse First Boston, 1999, The CSFB

Portfolio Design: A Modern Approach to Asset Allocation

by R. Marston  · 29 Mar 2011  · 363pp  · 28,546 words

/d QC: e/f JWBT412-Marston T1: g December 8, 2010 64 17:32 Printer: Courier Westford PORTFOLIO DESIGN As in the case of the equity risk premium, researchers have searched for reasons why value stocks outperform growth stocks on a risk-adjusted basis. An interesting approach is provided by a study by

Understanding Asset Allocation: An Intuitive Approach to Maximizing Your Portfolio

by Victor A. Canto  · 2 Jan 2005  · 337pp  · 89,075 words

recent years has been an ugly one. But most black ink dedicated to corporate accounting scandals, questionable capital structures, distorted executive-compensation packages, and rising equity risk premiums has failed to pinpoint an important source of the ugliness: Each undesirable episode was in part influenced by the tax changes that took place over

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tax story goes a long way toward explaining the 1970s’ bear market and the 1980s’ and 1990s’ extraordinary bull market, and explaining why the socalled equity risk premium increased steadily during the 1980s and 1990s. To best understand the relationship between taxation and the market, we need to modify existing formulas used in

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. The capitalized earnings model and the La Jolla Economics (LJE) modifications to it are only two of the many valuation models used to determine the equity risk premium and whether the market is overvalued or undervalued or the P/E ratio too high or too low. Other examples are Asness (2000), Campbell and

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, Clifford S. “The Interaction of Value and Momentum Strategies.” Financial Analysts Journal 53, No. 2 (March/April 1997): 29–36. ———. “Stocks Versus Bonds: Explaining the Equity Risk Premium.” Financial Analysts Journal 56, No. 2 (March/April 2000): 96–113. Baca, Sean P., Brian L. Garbe, and Richard A. Weiss. “The Rise of Sector

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that buys stock on the employees’ behalf. equal weighting Gives equal emphasis so every company’s price movement has the same effect on the index. equity risk premium The extra return the overall stock market or a particular stock must provide over the rate of Treasury bills (T-bills) to compensate for market

Adaptive Markets: Financial Evolution at the Speed of Thought

by Andrew W. Lo  · 3 Apr 2017  · 733pp  · 179,391 words

of four. By reducing equity exposure when volatility is high, the risk-managed benchmark holds more cash when the equity risk premium is lower than average, and it holds more equity when the equity risk premium is higher than average, exploiting the inverse relationship between stock prices and volatility documented by Black over four decades ago

All About Asset Allocation, Second Edition

by Richard Ferri  · 11 Jul 2010

. Figure 8-5 illustrates the rolling 12-month correlation between excess return on investment-grade bonds and excess return on equities (credit risk premium to equity risk premium). The credit risk premium is calculated by subtracting the monthly return on the Barclays Capital Intermediate-Term Treasury Index 1–10 Years from the return

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on the Barclays Capital Intermediate-Term Credit Index 1–10 Years. The equity risk premium is calculated by subtracting the return on Treasury bills from the return on the CRSP 1–10 Total Stock Market Index. Measuring the correlation between

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these two returns tells us if there is a relationship between them. The average 12-month correlation between the credit risk premium and the equity risk premium suggests that at times the credit risk is related to the same factors affecting equity returns and that those times are particularly strong at the

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onset of an economic Fixed-Income Investments FIGURE 155 8-5 12-Month Rolling Correlation between the Credit Risk Premium and the Equity Risk Premium 1.0 0.8 0.5 0.3 0.0 ⫺0.3 ⫺0.5 The correlation between two risk premiums: ⫺0.8 Corporate bonds (less

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stock dividends without shareholder approval. This is all reflected in greater price volatility in stocks over bonds. Figure 11-6 illustrates the rolling 10-year equity risk premium based on the 10-year return on stocks as measured by the CRSP 1–10 Total U.S. Stock Market Index over the 10-year

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(or loss) that U.S. common stock returned over corporate bonds in rolling 10-year periods. CHAPTER 11 230 FIGURE 11-6 Rolling 10-Year Equity Risk Premium over Corporate Bonds 20% Excess return of stocks over long-term corporate bonds 10-year moving average 15% 10% 5% Long-term Average 0% ⫺5

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% 2009 2005 2001 1997 1993 1989 1985 1981 1977 1973 1969 1965 1961 1957 1953 1949 1945 1941 ⫺15% 1937 ⫺10% The equity risk premium is far from consistent. The difference between the 10-year annualized returns from stocks and bonds has varied from about minus 8 percent to plus

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-term estimation of the risk premium. Given the risk of stocks and the current valuation of the market, a good prediction for the long-term equity risk premium going forward is about 3 percent annualized over long-term corporate bonds. I’ll take a conservative view on the equity premium over corporate bonds

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and give it a 2 percent annualized expectation. U.S. equity expectation ⫽ expected long-term corporate bonds ⫹ equity risk premium There are other risk premiums that can be applied to the expected return on a portfolio in addition to the inherent risk of the equity

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Layering Risk Premiums T-Bills IntermediateTerm Treasury Notes IntermediateTerm LargeCorporate Cap Bonds Stocks Real risk-free rate Term risk premium (intermediate) Credit risk premium (intermediate) Equity risk premium Value stock risk premium Small stock risk premium 0.5 0.5 0.5 0.5 0.5 1.5 1.5 1.5 1

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