Investment Returns and Securities Market Risk Premiums Articles

What have average investment asset class risk premiums been over long periods?

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.

Asset class investment risk premiums -- your reward for taking investment risk

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.

How stable have common stock market returns been over time?

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.

What might explain the dramatic rise in common stock equity prices during the 1980s and 1990s?

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.

What explains the recent common stock equity risk premium?

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.

How do return expectations of investors compare to historical stock returns and risk premiums?

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.

What common stock returns might individual investors expect going forward?

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.

To estimate the future common stock risk premium, how might individual investors extrapolate from the past?

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.

What happens to the expected equity premium, when the common stock P/E ratio reverts toward historical norms?

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.

How are asset class risk premiums and the risk free rate of return related?

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.