Does the equity risk premium justify the risk?

Question

A survey of professional investors in the U.S.

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found thattheir average estimate of the equity risk premium (ERP) over 10-yearTreasury bonds was about 3.5% a year . One-year implied volatility forthe S&P 500 is about 25%, and one-month implied volatility is about28% (as measured by VIX). Risking about 20% a year to earn 3.5% seemslike insufficient reward for risk to me. The question is whether expected returns are higher when volatility is above average, as it is now. It's also possible that the 3.5% ERP estimate is too low, although many academics have come to similar conclusions. If nominal GDP rises at say 6% a year, (3% nominal, 3% real) and dividend yields stay at 2% it's tough to envision stocks returns being 12% a year, implying 10% annual price appreciation, since then the ratio of stock market capitalization to GDP would increase without bound.

As a financial professional I am forced to follow the markets daily, and seeing one's net worth bounce around by 1 to 2% a day for a 3.5% annual reward is even more unpleasant. OK, partly I'm just grumbling about the recent market action, but I think it would be interesting to see how suggested asset allocations for an investor depend on one's estimates for stock market volatility and return.

Stock market volatility is especially painful because stock returns tend to be worse in "bad" states of the world, for example states with soaring commodity prices, collapsing banks, and rising unemployment.

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Elizabeth Richardson · Accepted Answer

Another bear? Goody, goody. Come on bears, get out in the open, the more of you, the better. A distinct lop-sidedness of either bears or bulls is a contrarian indicator. Lots of bears means we're near a bottom, just as when there are too many bulls, we're near a top.

Elizabeth Richardson

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Douglas Johnson · Answer

Then you'll love this.  My favorite contrarian indicator is the AmericanAssociation of Individual Investors (AAII) investor sentiment poll.  It measureshow the members feel about the market over the next six months.Currently it is:Bullish 22.17%  -- the long term average is 39.2%Neutral 22.66% - the long term average is 31.6%Bearish 55.17% - the long term average is 29.3%Here's the juicy part:Bullish: Max: 75.0% (1/6/2000), Min: 12.0% (11/16/1990) Neutral:  Max: 62.0% (6/3/1988), Min: 8.0% (12/14/2000) Bearish:  Max: 67.0% (10/19/1990), Min: 6.0% (8/21/1987) So the bulls set a record high and the bears set a record low just before the2000 debacle  The bear minimum was just before the 1987 crash and the bullminimum was just before the 1991 boom.So, bears, bring it on.  There is enough doom and gloom  that I am starting tothink there might be a bottom somewhere.  Not soon, I am always too early onthis kind of thing.Just a brief plug for the AAII.  I've been a member for over 20 years. ...

David Moore · Answer

I'm not sure how much subjective estimates of the equity risk premium are worth. Here are my notes on the Dimson et al. study of data for the entire 20th century:

(The equity risk premium is ...) Extremely variable annually, roughly normal mean 7.7% std dev 19.6. Geometric 1900-2000 5.8% over bills. Same ballpark internationally. Ten-year premia: arithmetic 5.8% with std dev 5.4%, geometric 5.6%. NOTE lower than most previous studies due to longer time frame.

David

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Ron Peterson · Answer

•9703found that> their average estimate of the equity risk premium (ERP) over 10-year> Treasury bonds was about 3.5% a year . One-year implied volatility for> the S&P 500 is about 25%, and one-month implied volatility is about> 28% (as measured by VIX). Risking about 20% a year to earn 3.5% seems> like insufficient reward for risk to me.As one who is investment portfolio is heavy in equities, I feel thatvolatility.I think that high volatility is being driven by professional investorsmanaging the different funds and won't be going away withoutlegislation. Investment returns are driven by how profitable thecompanies are and how much is left for the stock holders, not thevolatility of the stock price.That 3.5% extra return will result in almost 100% more after 20 years,so it's a no brainer.A person can now invest in most countries of the world through ADRsand ETFs reducing risk, but not much reduction in volatility.--    Ron-------------------------------------- is a moderated newsgroup...

Does the equity risk premium justify the risk?

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