What is the current equity risk premium, and how calculated?

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Browser
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What is the current equity risk premium, and how calculated?

Post by Browser » Fri Sep 13, 2013 9:37 am

How is the equity risk premium calculated - are there various methods for doing it? If I wanted to calculate the current ERP, how would I do it and what is the solution? Are there various solutions that more-or-less agree or are there multiple solutions with a wide range?
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Re: What is the current equity risk premium, and how calcula

Post by psteinx » Fri Sep 13, 2013 9:51 am

I assume that you mean what is the expected relatively long term return of equities over a safer benchmark (either T-Bills or 10 year treasuries, most likely).

Short answer is that there is no uniform expectation, nor uniform methodology, and that there is a lot of debate about the topic.

Methods for calculating an expected forward ERP include projections of past ERPs (historical), and methods that attempt to take current/recent valuations into account in various ways.

Lots of different folks have their favorite calculations/estimates, and you will likely see of them in this thread.

I don't want to write a long dissertation here enumerating many of the most popular or my own favorites, but will say that if you search through the archives of this forum, you should find some discussion on the topic in the past. (It's not a SUPER popular topic here, IMO, but it does get discussed from time to time).

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Re: What is the current equity risk premium, and how calcula

Post by larryswedroe » Fri Sep 13, 2013 10:29 am

Only one way to calculate the HISTORICAL ERP
You take the ANNUAL AVERAGE (not compound) return on TSM and SUBTRACT the ANNUAL AVERAGE return on one-month TBILLS.

Calculating the expected ERP is a whole other ball game.
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Re: What is the current equity risk premium, and how calcula

Post by Browser » Fri Sep 13, 2013 10:32 am

Just what are some of the current, credible estimates of the ERP going forward? Also, is the estimated ERP supposed to represent the annual premium over the next year, 30 years, or to infinity?
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Re: What is the current equity risk premium, and how calcula

Post by Ricola » Fri Sep 13, 2013 10:45 am

The ERP is routinely reported in the Economist magazine, believe author is Aswath Damodaran, and most recently reported as historically high.

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Re: What is the current equity risk premium, and how calcula

Post by Rodc » Fri Sep 13, 2013 10:54 am

Browser wrote:Just what are some of the current, credible estimates of the ERP going forward?
Evidence is there is no such beast.

If you must, try the Gordon Equation.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Re: What is the current equity risk premium, and how calcula

Post by Browser » Fri Sep 13, 2013 11:40 am

Rodc wrote:
Browser wrote:Just what are some of the current, credible estimates of the ERP going forward?
Evidence is there is no such beast.

If you must, try the Gordon Equation.
I thought that the expected ERP was the linchpin of the investment universe. How can anybody figure out their tolerable asset allocation unless they make some assumptions about how much reward they expect to accrue from assuming the risk of investing in equities instead of putting the money under the mattress? I guess Jack and Jill Sixpack just assume it's "high", eh? If it's just a guess, then how in the heck can anybody justify putting much money into the casino?
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Re: What is the current equity risk premium, and how calcula

Post by larryswedroe » Fri Sep 13, 2013 12:00 pm

IMO as good an estimate of the return on stocks is the adjusted E/P of Shiller CAPE 10
So today 24.15 inverted to 4.14. Then adjust for the average lag in earnings of 5 years by multiplying by 1.075 (1.5% real historical growth in earnings) and you get a real return forecast of about 4.5%.
So now you have to subtract real rate on risk free instrument. What do you use with real rate currently big negative on one-month bills, or very if you like very short TIPS.

Another way might be to subtract long term average of about 0.7 on real yield on one-month bills through 2012 was 0.5 percent. That would get you about 4% for the ERP.

Hope that helps
Larry

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Re: What is the current equity risk premium, and how calcula

Post by berntson » Fri Sep 13, 2013 12:11 pm

Larry also talks about this in his book. One way to do it is to estimate future market returns as growth + dividend yield + inflation. If you are only interested in real returns, then it's just growth and dividends. Current dividend yield is 2%. I use a conservative 2% estimate for growth (Larry suggests doing this in part because of the phenomenon of "leakage" in economic growth. Some of the growth goes to venture capitalists rather than the overall market). This gives a 4% estimate going forward for real returns with a bit of margin for safety. Add 3.2% or so to get the nominal returns (since that's the historic rate of US inflation).

Since these estimates are for long-term planning purposes, I see no particular reason to look for "current" estimates. I doubt that any recent events or market conditions will do much to help us figure out what the market will do in 20 years. I just use 4% as a fairly conservative estimate and hope that I'll be pleasantly surprised!

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Re: What is the current equity risk premium, and how calcula

Post by YDNAL » Fri Sep 13, 2013 1:02 pm

Browser wrote:I guess Jack and Jill Sixpack just assume it's "high", eh? If it's just a guess, then how in the heck can anybody justify putting much money into the casino?
Nothing wrong with educated "guesses."

Anyhow, this is what Jack Bogle does to guess at 4.5% real for Equities. A 0% guess for risk-free options today is as good a guess as any :) .
http://www.morningstar.com/cover/videoc ... ?id=571370
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Re: What is the current equity risk premium, and how calcula

Post by richard » Fri Sep 13, 2013 1:11 pm

Vanguard found p/e (regular or Shiller's p/e10) to be the best predictor of stock returns, but it's not a very good predictor
https://personal.vanguard.com/pdf/s338.pdf

Current bond yields are the best predictor of bond yields, but they're not a very good predictor either.

As noted, there is lots of disagreement over definitions and methodology.

What do you intend to do with the information? It's much easier to give a meaningful answer to your question if we know why you're asking.

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Re: What is the current equity risk premium, and how calcula

Post by momar » Fri Sep 13, 2013 1:23 pm

Browser wrote:
Rodc wrote:
Browser wrote:Just what are some of the current, credible estimates of the ERP going forward?
Evidence is there is no such beast.

If you must, try the Gordon Equation.
I thought that the expected ERP was the linchpin of the investment universe. How can anybody figure out their tolerable asset allocation unless they make some assumptions about how much reward they expect to accrue from assuming the risk of investing in equities instead of putting the money under the mattress? I guess Jack and Jill Sixpack just assume it's "high", eh? If it's just a guess, then how in the heck can anybody justify putting much money into the casino?
Some things are unknowable, no matter how much we wish otherwise. It doesn't mean you need to be paralyzed. The market is also not a casino.
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Re: What is the current equity risk premium, and how calcula

Post by magician » Fri Sep 13, 2013 2:26 pm

4.3%

Pulling it out of . . . the air.

(That's what most people do; I'm one of the rare few willing to admit it.)
Simplify the complicated side; don't complify the simplicated side.

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Re: What is the current equity risk premium, and how calcula

Post by nisiprius » Fri Sep 13, 2013 2:50 pm

Browser wrote:I thought that the expected ERP was the linchpin of the investment universe.
Hah! See this thread:The Equity Risk Premium from 150 textbooks and the paper it references.
I review 150 textbooks on corporate finance and valuation published between 1979 and 2009 by authors such as Brealey, Myers, Copeland, Damodaran, Merton, Ross, Bruner, Bodie, Penman, Arzac… and find that their recommendations regarding the equity premium range from 3% to 10%, and that 51 books use different equity premia in various pages. The 5-year moving average has declined from 8.4% in 1990 to 5.7% in 2008 and 2009.
He also found at least four different meanings and definitions for the term "equity risk premium."

As John C. Bogle wrote in Clash of the Cultures, "Investing is not a science." There's nothing wrong with that except that people pretend it is much more scientific than it is, and are willing to leave people with the impression that things are far better known and far more precise than they are.
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Re: What is the current equity risk premium, and how calcula

Post by scone » Fri Sep 13, 2013 3:00 pm

Browser wrote: I thought that the expected ERP was the linchpin of the investment universe. How can anybody figure out their tolerable asset allocation unless they make some assumptions about how much reward they expect to accrue from assuming the risk of investing in equities instead of putting the money under the mattress? I guess Jack and Jill Sixpack just assume it's "high", eh? If it's just a guess, then how in the heck can anybody justify putting much money into the casino?
Inflation. If not for that threat, many people would indeed put their money somewhere safer. One of my major goals was to find a stock percentage that would have a pretty good chance (not a certainty) of staying even with average levels of inflation. I don't need any more stock risk than that.
"My bond allocation is the amount of money that I cannot afford to lose." -- Taylor Larimore

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Re: What is the current equity risk premium, and how calcula

Post by YDNAL » Fri Sep 13, 2013 3:37 pm

nisiprius wrote:As John C. Bogle wrote in Clash of the Cultures, "Investing is not a science." There's nothing wrong with that except that people pretend it is much more scientific than it is, and are willing to leave people with the impression that things are far better known and far more precise than they are.
Oh, yeah!

When taken to task, though, folks as you mentioned claim to always admit the future is unknown, admit to uncertainties, admit, admit....
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Re: What is the current equity risk premium, and how calcula

Post by Browser » Fri Sep 13, 2013 4:57 pm

I note that Arnott & Bernstein (Peter) estimated long term stock market returns as the current dividend yield on the market plus the long term real growth in dividends, which has averaged about 0.9% over the last 200 years or so in the U.S. That gets us to an estimated equity return of 2.75% (1.85% dividend yield + 0.9%). Then, if you subtract the long term real return of T-Bills of 0.7%, you get to an estimated ERP of about 2% currently. I've seen other estimates in the same territory -- considerably lower than the 5% historical ERP since 1926. Just my gut, but 4% sounds pretty optimistic, given that the 5% historically observed ERP in the U.S. isn't likely to be repeated. (How many times can you grow from an emerging economy to a world superpower?)
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Re: What is the current equity risk premium, and how calcula

Post by nisiprius » Fri Sep 13, 2013 5:35 pm

The problem is that once you accept the dividend discount theory of stock values, which I do, it doesn't really get you anywhere, because the future of dividends is unpredictable, and the market's guesses at the future of dividends and interest rates is just... the same guess as stock prices, which are unpredictable.

It's all "if we had ham, we could have ham and eggs--if we had some eggs."

People talk about "long term real growth in dividends" that leads you to infer that they somehow are more predictable than anything else. They never actually say it is, they just talk about it as if it were...
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Re: What is the current equity risk premium, and how calcula

Post by Browser » Fri Sep 13, 2013 5:45 pm

nisiprius wrote:The problem is that once you accept the dividend discount theory of stock values, which I do, it doesn't really get you anywhere, because the future of dividends is unpredictable, and the market's guesses at the future of dividends and interest rates is just... the same guess as stock prices, which are unpredictable.

It's all "if we had ham, we could have ham and eggs--if we had some eggs."

People talk about "long term real growth in dividends" that leads you to infer that they somehow are more predictable than anything else. They never actually say it is, they just talk about it as if it were...
Except the long term growth of dividends is a pretty solid number. It's not like the real dividend growth rate has an SD of 99 or something. And here we're talking about the growth of real dividends (taking inflation into account) which is a good estimate of the long term real IRR of equities. My take is that the authors are saying that long term expected equity returns ought to reflect the expected IRR.
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Re: What is the current equity risk premium, and how calcula

Post by berntson » Sat Sep 14, 2013 1:11 am

Hmmm...seems like the moral of the story is that no one really knows what the equity premium will be, and it's worth having a portfolio and savings plan that will be alright if the premium gets significantly smaller or goes away entirely.

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Re: What is the current equity risk premium, and how calcula

Post by YDNAL » Sat Sep 14, 2013 5:26 am

berntson wrote:Hmmm...seems like the moral of the story is that no one really knows what the equity premium will be, and it's worth having a portfolio and savings plan that will be alright if the premium gets significantly smaller or goes away entirely.
Bingo.

Don't underestimate the power of the Markets to humble you (or anyone). The best predictor to meet a future goal is to SAVE for this goal. Everything else, regardless of the source, are based on wags
(wild ass guesses) - educated as the wags may be.
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Re: What is the current equity risk premium, and how calcula

Post by JoMoney » Sat Sep 14, 2013 5:32 am

The problem with the idea of a "risk premium" is that they aren't persistent. It makes a great story, but there are lots of obvious failings. People's sentiments and other issues get involved and markets can get off kilter to super highs and lows with no regard for the actual risks.
Warren Buffet - 2005 Student Visit wrote:Stocks usually yield a little more, but that isn't ordained. Every once in a while, stocks will get very cheap, but it isn't ordained in scripture that this is so. Risk premiums are mostly nonsense. The world isn't calculating risk premiums.

The best book prior to Graham was written by Edgar Lawrence Smith in 1924 called Common Stocks as Long Term Investments. It was a study that evaluated how bonds compared to stocks in various decades of the past. There weren't a whole lot of publicly traded companies back then. He thought he knew what he was going to find. He thought that he'd find that bonds outperformed stocks during periods of deflation, and stocks outperformed during inflationary times. But what he found was that stocks outperformed the bonds in nearly all cases. John M. Keynes then enumerated the reasons that this was so. He said that over time you have more capital working for you, and thus dividends would grow higher. This was novel information back then and investors then went crazy and started buying stocks for these higher returns. But then they started to get crazy, and no longer really applied the sound tactics that made the reasons given in the book true. Be careful that when you buy something for a sound reason, make sure that the reason stays sound.
John Maynard Keynes, The General Theory of Employment, Interest and Money wrote:But there is one feature in particular which deserves our attention. It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence. ...
This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional; — it can be played by professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity.
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Re: What is the current equity risk premium, and how calcula

Post by Browser » Sat Sep 14, 2013 9:40 am

I think those observations about risk premium are intriguing. Even if everyone agreed on how to estimate the expected risk premium, the realized risk premium isn't even close, for the most part. Isn't there supposed to be a reasonable correspondence? The main value I can discern is that the expected risk premium might be a sort of valuation measure. When the consensus is for a high expected premium, it's probably time to head for the hills; and vice versa. So, if I believe Larry's ERP of 4, which is close to the long term realized RP of 5, I should probably trim back my equity allocation. If I believe Arnott & Bernstein's ERP of 2, maybe not.
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Re: What is the current equity risk premium, and how calcula

Post by larryswedroe » Sat Sep 14, 2013 12:46 pm

Browser the long term ERP looking at compound returns is about 7%, when looking at beta factor (annual average returns) it's about 8.0

And of course risk premiums are unstable or there would be no risk!!!! That is in fact why they are referred to ask risk premiums. And the risk is there no matter how long the horizon.

Having said that we do know a fair amount like there is a good correlation between e/p and returns- the higher the e/p the higher the 10-year returns have been, the higher the best outcomes have been and the lower the worst outcomes have been--And it's monotonic as you move to higher and higher e/p. Not coincidence. Of course it's important to add that the spread between the worst and best returns for the same e/p are very wide (that's risk)

Best wishes
Larry

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Re: What is the current equity risk premium, and how calcula

Post by nisiprius » Sat Sep 14, 2013 1:29 pm

Wikipedia's summary of the Equity premium puzzle says
The process of calculating the equity risk premium, and selection of the data used, is highly subjective to the study in question, but is generally accepted to be in the range of 3-7% in the long-run.

Dimson et al. calculated a premium of "around 3-3.5% on a geometric mean basis" for global equity markets during 1900–2005 (2006)....

The puzzle has led to an extensive research effort in both macroeconomics and finance. So far a range of useful theoretical tools and several plausible explanations have been presented, but no one solution is generally accepted by economists.
As it often does, Wikipedia gives an assortment of references to respectable-sounding academic journals. I am inclined to think Dimson et al. probably really said what Wikipedia says they said.

Actually their link to The Worldwide Equity Premium: A Smaller Paradox checks out, and the paper's abstract is:
We use a new database of long-run stock, bond, bill, inflation, and currency returns to estimate the equity risk premium for 17 countries and a world index over a 106-year interval. Taking U.S. Treasury bills (government bonds) as the risk-free asset, the annualised equity premium for the world index was 4.7% (4.0%). We report the historical equity premium for each market in local currency and US dollars, and decompose the premium into dividend growth, multiple expansion, the dividend yield, and changes in the real exchange rate. We infer that investors expect a premium on the world index of around 3-3 1/2% on a geometric mean basis, or approximately 4 1/2-5% on an arithmetic basis.
I don't quite understand this, but it appears as if professional economists don't even agree on whether the arithmetic or geometric mean should be used?????
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Re: What is the current equity risk premium, and how calcula

Post by YDNAL » Sat Sep 14, 2013 2:41 pm

larryswedroe wrote:Browser the long term ERP looking at compound returns is about 7%, when looking at beta factor (annual average returns) it's about 8.0
Journal of Finance, Vol LVII, No. 2, April 2002 (need registration)
Eugene F. Fama and Kenneth R. French
http://www.jstor.org/discover/10.2307/2 ... 2637865487
The average real return for 1872 to 2000 on the S&P 500 index (a common proxy for the market portfolio, also used here) is 8.81 per cent. The average real return of six-month commercial paper (proxy for the risk-free interest rate) is 3.24 per cent. This large spread (5.57 per cent) between the average stock return and the interest rate is the source of the so-called equity risk premium puzzle: Stock returns seem too high given the observed volatility of consumption (Mehra and Prescott (1985)).
I can reconcile this.
larryswedroe wrote:And of course risk premiums are unstable or there would be no risk!!!! That is in fact why they are referred to ask risk premiums. And the risk is there no matter how long the horizon.
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Re: What is the current equity risk premium, and how calcula

Post by larryswedroe » Sat Sep 14, 2013 4:53 pm

YDNAL
I have no idea why FF chose to you the six month CP rate---no one has ever done that. So you get a much higher "risk free rate" and lower ERP. Now of course CP is not riskless. The only metric ever used (at least I've seen) to calculate ERP and beta is the one-month Tbill rate (the riskless rate)
And of course FF used different time period---I used the generally used one which starts in 1926, not 1872.
Best
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Re: What is the current equity risk premium, and how calcula

Post by Browser » Sat Sep 14, 2013 5:22 pm

The “bible” for the return assumptions that drive our industry
is the work of Ibbotson Associates, building on the
pioneering work of Ibbotson and Sinquefield (1976a,
1976b). The most recent update of the annual Ibbotson
Associates data (2001) shows returns for U.S. stocks, bonds,
bills, and inflation of, respectively, 11.0 percent, 5.3 percent,
3.8 percent, and 3.1 percent. These figures imply a real
return for stocks of 7.9 percent and a risk premium over
bonds of 5.7 percent (570 bps), both measured over a 75-year
span.
The 5.7% has been the historically realized risk premium of stocks over bonds. However
if we examine the historical
record, neither the 8 percent real return nor the 5
percent risk premium for stocks relative to government
bonds has ever been a realistic expectation
,
except from major market bottoms or at times of
crisis, such as wartime.
A 5 percent excess return on stocks over bonds
compounds so mightily over long spans that most
serious fiduciaries, if they believed stocks were
going to earn a 5 percent risk premium, would not
even consider including bonds in a portfolio with a
horizon of more than a few years: The probabilities
of stocks outperforming bonds would be too high to
resist.
http://www2.mccombs.utexas.edu/faculty/ ... 0faj02.pdf
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Re: What is the current equity risk premium, and how calcula

Post by JoMoney » Sat Sep 14, 2013 7:03 pm

That's a good paper, thank you for sharing that.

I want to point out though that the paper was written around 2002 and was focused on a time period where P/E ratios were still in the high 30's representing an earnings yield of 2-3% while government bonds were yielding 5%. Corporate earnings can change considerably (up or down) over time, so P/E alone isn't a good indicator as to what the future brings. Looking backwards, over long periods of time the total return in the market is quite reasonably explained by the prior earnings over that period but it does not predict the future earnings.
If the sentiment of the market is that earnings will grow much faster, or that some greater fool will pay more for less earnings, it may be quite reasonable to pay a higher multiple on corporate earnings over the fixed rate of bond yields. Likewise if the sentiment is that earnings will fall or be stagnate relative to bond yields it could be rational that P/E will be low relative to bond yields. Or irrespective of what corporate earnings are, there could be some irrationally exuberant fellow buying $80billion dollars of bonds every month without regard to any "premium" any rational investor might expect the market would maintain.

Former fed chairman Alan Greenspan certainly thinks there is currently a high equity premium
Alan Greenspan wrote: http://www.cnbc.com/id/100798203
"The most important positive force in the economy at the moment is the fact that equity premiums are so high, which means the downside on stock prices is quite limited" ... "If we can get stock prices to rise, which they will if this thing stabilizes, then you get a lot of asset-growth effect on the economy."
"Bond prices have got to fall. Long-term rates have got to rise. The problem, which is going to confront us, is we haven't a clue as to how rapidly that's going to happen. And we must be prepared for a much more rapid rise than is now contemplated in the general economic outlook."
"We're still well below the [rate] level we normally ought to be at this stage," he said. "The consequence of that is that when the bond market begins to move we may not be able to control it as well as we'd like to. And that has a lot of ramifications with respect to all sorts of markets."
It seems to me, that premiums go back and forth between different asset classes over time, and that past results do not indicate future results, and that the market itself is not always correct in pricing in premiums. Leading to perhaps the best course of action being to diversify across asset types and across time by dollar-cost-averaging in.
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Re: What is the current equity risk premium, and how calcula

Post by docneil88 » Thu Sep 19, 2013 10:42 pm

larryswedroe wrote:IMO as good an estimate of the return on stocks is the adjusted E/P of Shiller CAPE 10
So today 24.15 inverted to 4.14. Then adjust for the average lag in earnings of 5 years by multiplying by 1.075 (1.5% real historical growth in earnings) and you get a real return forecast of about 4.5%.
I've seen Jeremy Siegel also use the same method of forecasting long term returns, but with PE1 instead of PE10. Professor Siegel noted:
The historical data confirm this [method]. In the United States, data of corporate profits go back to 1870 and the average P-E ratio during that period has been 14.4, leading to an average earnings yield of 6.9%. This is one-tenth percentage point above the average real return on equities, which is 6.8% over the period.[Source http://finance.yahoo.com/expert/article ... vest/30733 , but the link no longer works]
Note that both Siegel's and Swedroe's methods apparently assume the respective earnings yield will remain the same at the end of the forecast period. One thing neither Swedroe's nor Siegel's methods adjust for is any reversion back to the historical mean PE, or to the historical mean ERP (Equity Risk Premium). E.g. The current PE10 is 24.6 vs. a mean of 16.5 since 1881. If one wanted to adjust for such a mean reversion, what would be a reasonable period over which to project the mean reversion will occur? 10 years? Based on what? Best, Neil
Last edited by docneil88 on Thu Sep 19, 2013 10:44 pm, edited 1 time in total.

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abuss368
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Re: What is the current equity risk premium, and how calcula

Post by abuss368 » Thu Sep 19, 2013 10:44 pm

Hopefully Rick Ferri will be able to provide some insight.
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Bustoff
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Re: What is the current equity risk premium, and how calcula

Post by Bustoff » Sat Sep 21, 2013 5:40 am

When calculating the real expected return of equities, William Bernstein, in his book, Investors Manifesto, advocates use of the Gordon Equation, which is calculated as follows:

Expected Return = Dividend Yield + Dividend Growth Rate.

Bernstein strongly suggests that investors should "always favor expected returns calculated from the Gordon Equation over past returns, no matter how long of a period they cover."

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