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 Investment Returns and Securities Market Risk Premiums Articles
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(18519 reads)
Over the past two hundred years, real or non-inflationary equity market returns have averaged just under 7%. During the 19th century, cash and bond returns “were king” and additional equity risk returns were relatively small. In the 20th century and particularly during the second half of that century, investors were much more richly rewarded for carrying the risks associated with equity investments.
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(12319 reads)
Risk premiums compensate investors for taking some of the risks associated with financial securities. To enable payment of risk premiums, markets set current prices at a discount relative to expected future prices.
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(22294 reads)
The short-term common stock equity premium, which averaged about 4.1% from 1872 to 2000, has varied widely in the past. Measured by decades over the past 130 years, it was over 10% in four decades, between 0% and 5% in seven decades and negative in two decades.
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(6782 reads)
The long-term fixed income and equities markets of the 1980s and 1990s performed very differently that the markets of the past two centuries. Whether recent trends will continue or not is an open question with essentially unknowable answers. However, the longer history indicates that it would be reasonable to expect both fixed income and equity returns to be lower.
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(9775 reads)
In a widely referenced scientific investment paper, Professors Fama and French concluded that the average investor lowered his discount rate for equities over the 1980s and 1990s. Much of the extraordinary equity appreciation over this period was the result of investors simply being willing to pay a higher price for an ordinary dollar of returns.
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(25102 reads)
At the peak of the market bubble, many stock market participants had extremely high return expectations. The consensus of investment science is that the long-term equity risk premium is 4% to 5%. In the wake of an extended and brutal post-bubble bear market, investor return expectations in the second half of 2004 were much diminished. However, their expectations were still over twice as high as the long-term historical equity risk premium.
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(12221 reads)
Obviously, no one really knows or can know what common stock returns will be going forward. Using rationally based estimates of the forward-looking equity premium, investors should probably not expect anything like a repetition of equity market returns during the 1980s and 1990s. Performance in those decade was simply exceptional and not the norm.
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(12884 reads)
The past is the only source of guidance on how securities markets might perform in the future. Investors face critical choices about which method to use when extrapolating from the past. A study by Professors Fama and French provides individual investors with important guidance on which scientific methods to use. With these methods, a real or non-inflationary equity premium of between 3.8% and 4.8% could be a rationally derived estimate of the real forward equity premium.
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(10250 reads)
U.S. equities prices have had a long-term tendency to revert toward their average price to earnings ratio. In the 1980s and 1990s, the PE had increased substantially above the long-term average. Much, but not all, of this reversion occurred in the first five years of the 21st century.
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(15778 reads)
Risk premiums are estimated relative to a baseline “risk-free” rate of return. The risk free rate of return in the scientific investment literature has been measured by either short-term U.S. T-bills or by long-term U.S. T-bonds.
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