In 2001, a small group of academics and practitioners met to discuss the equity risk premium (ERP). Ten years later, in 2011, a similar discussion took place, with participants writing up their thoughts for this volume. The result is a rich set of papers that practitioners may find useful in developing their own approach to the subject.
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5 of 5 people found the following review helpful
Format:Paperback
What a wonderful monograph this is. I wanted to share with you comments from the RF Research Director Larry Siegel:
In the book, Rethinking the Equity Risk Premium, edited by Brett Hammond, Martin Leibowitz, and Laurence Siegel, published by the Research Foundation of CFA Institute, a number of prominent thinkers express their views on this most important financial variable. The book is the outcome of a colloquium held in New York in January 2011 at the offices of TIAA-CREF, roughly on the 10th anniversary of the first equity risk premium forum organized by the CFA Institute.
In the first chapter, Brett Hammond and Martin Leibowitz provide an overview of Rethinking the Equity Risk Premium, reflecting on the changes in methods and estimates since the CFA Institute (then known as AIMR) sponsored the first equity-premium roundtable a decade ago. They then present their view of the question, focusing on the idea that different investors experience differently sized equity premia.
Roger Ibbotson's contribution is to consider the many ways in which the term "equity risk premium" can be used. The many uses of the term lead to confusion. Ibbotson notes that the premium may be historical or forward-looking; it may be measured in excess of bond yields or returns, cash returns, or inflation rates; and it may be an arithmetic mean or geometric mean. The confusion is eliminated by carefully defining what one means by the equity risk premium.
Clifford Asness argues that the stock market is expensive, based on an analysis of the "Shiller P/E" (current price divided by trailing 10-year average real earnings). As a result, he expects an equity total return - not a risk premium - in the range of 4%. Because it is difficult to agree on a riskless rate with which to compare this number, Asness does not set forth a specific risk premium estimate.
Elroy Dimson, Paul Marsh, and Mike Staunton examine evidence across many countries. While the equity premium varies from one country to another, it has been substantial in all of the countries when measured starting in 1900. They use a supply-side (GDP-linked) model to estimate the forward-looking premium, which is lower than the historical premium because they expect lower dividend growth in the future than in the past.
Richard Grinold, Kenneth Kroner, and Laurence Siegel update Grinold and Kroner's 2002 estimate of the equity premium, which relies on a link to GDP growth rates. In particular, the authors move beyond equating dividend growth with GDP growth to consider how the two rates can be expected to differ. They forecast a geometric mean equity risk premium, over 10-year Treasury bonds, of 3.6%.
Robert Arnott debunks a number of myths surrounding the equity premium. Among these myths are the existence of a stable premium around 5 percentage points over bonds; that the risk of stocks all but goes away in the long run; that earnings grow as rapidly as GDP; that dividends do not matter; and so forth. He shows how each of the myths came to be widely accepted as truth, and demonstrates why he believes each of these to be untrue or misleading.
Antti Ilmanen focuses on the time-varying aspect of the equity premium. He uses quantitative methods to demonstrate that the premium has varied substantially over time and to form his own forecast. There is also cross-sectional variation (that is, a term structure); in other words, the premium expected over one year differs from the premium expected over 10 years. Much of the cross-sectional variation in the premium comes from the term structure of bond yields.
Peng Chen turns the question around by asking whether bonds might outperform stocks over the long run as they have over the past decade. Currently, long-term bond yields are so low that they are unlikely to decline much further, so expected capital gains from bonds are low to negative. In contrast, stock returns depend on earnings growth and on changes in the P/E multiple. If earnings growth remains at roughly its historical average of 5%, Chen argues, it is almost mathematically impossible for bonds to beat stocks over a 40-year forecast horizon.
Andrew Ang and Xioyang Zhang conclude that the ERP is relatively stable over time. They decompose firms' future earnings into those associated with a perpetual, no-growth component and a component associated with future growth opportunities. This analysis shows that changes in growth opportunities, rather than in the no-growth component, explain the vast bulk of the variation in the P/E.
Jeremy Siegel looks back in history to the founding of the U.S. to emphasize continuities in the numbers that underlie the historical returns on equities and, thus, estimates of the equity risk premium. He shows that the two recent bear markets have not greatly affected the historical risk premium when measured over such a long time span. Siegel expects real stock returns of 6% to 7%, which translates to a risk premium of 5% to 6% (because real yields on Treasury bonds are only 1%).
Rajnish Mehra asks whether his original ground-breaking work, which predicted a very low ERP, has been vindicated by subsequent events. He proposes three sets of corrections to realized returns that make the "equity premium puzzle" literature, which Mehra originated, still relevant. Taken together, these corrections bring the equity risk premium within range of the numbers originally forecast by Mehra. One consequence of this analysis is that as the baby boom retires and raises the demand for bonds, it is possible that the ERP will be higher in the future.
The authors' estimates of the equity risk premium over intermediate-term U.S. Treasury bonds clustered around 4%, representing a much tighter range than was expressed in the 2001 forum. While this estimate is lower than the historically realized premium, it should be encouraging to investors who have suffered through more than a decade of bear markets and who may now worry that they missed their chance to invest profitably in equities.
Laurence B. Siegel
Research Director
Research Foundation of CFA Institute
In the book, Rethinking the Equity Risk Premium, edited by Brett Hammond, Martin Leibowitz, and Laurence Siegel, published by the Research Foundation of CFA Institute, a number of prominent thinkers express their views on this most important financial variable. The book is the outcome of a colloquium held in New York in January 2011 at the offices of TIAA-CREF, roughly on the 10th anniversary of the first equity risk premium forum organized by the CFA Institute.
In the first chapter, Brett Hammond and Martin Leibowitz provide an overview of Rethinking the Equity Risk Premium, reflecting on the changes in methods and estimates since the CFA Institute (then known as AIMR) sponsored the first equity-premium roundtable a decade ago. They then present their view of the question, focusing on the idea that different investors experience differently sized equity premia.
Roger Ibbotson's contribution is to consider the many ways in which the term "equity risk premium" can be used. The many uses of the term lead to confusion. Ibbotson notes that the premium may be historical or forward-looking; it may be measured in excess of bond yields or returns, cash returns, or inflation rates; and it may be an arithmetic mean or geometric mean. The confusion is eliminated by carefully defining what one means by the equity risk premium.
Clifford Asness argues that the stock market is expensive, based on an analysis of the "Shiller P/E" (current price divided by trailing 10-year average real earnings). As a result, he expects an equity total return - not a risk premium - in the range of 4%. Because it is difficult to agree on a riskless rate with which to compare this number, Asness does not set forth a specific risk premium estimate.
Elroy Dimson, Paul Marsh, and Mike Staunton examine evidence across many countries. While the equity premium varies from one country to another, it has been substantial in all of the countries when measured starting in 1900. They use a supply-side (GDP-linked) model to estimate the forward-looking premium, which is lower than the historical premium because they expect lower dividend growth in the future than in the past.
Richard Grinold, Kenneth Kroner, and Laurence Siegel update Grinold and Kroner's 2002 estimate of the equity premium, which relies on a link to GDP growth rates. In particular, the authors move beyond equating dividend growth with GDP growth to consider how the two rates can be expected to differ. They forecast a geometric mean equity risk premium, over 10-year Treasury bonds, of 3.6%.
Robert Arnott debunks a number of myths surrounding the equity premium. Among these myths are the existence of a stable premium around 5 percentage points over bonds; that the risk of stocks all but goes away in the long run; that earnings grow as rapidly as GDP; that dividends do not matter; and so forth. He shows how each of the myths came to be widely accepted as truth, and demonstrates why he believes each of these to be untrue or misleading.
Antti Ilmanen focuses on the time-varying aspect of the equity premium. He uses quantitative methods to demonstrate that the premium has varied substantially over time and to form his own forecast. There is also cross-sectional variation (that is, a term structure); in other words, the premium expected over one year differs from the premium expected over 10 years. Much of the cross-sectional variation in the premium comes from the term structure of bond yields.
Peng Chen turns the question around by asking whether bonds might outperform stocks over the long run as they have over the past decade. Currently, long-term bond yields are so low that they are unlikely to decline much further, so expected capital gains from bonds are low to negative. In contrast, stock returns depend on earnings growth and on changes in the P/E multiple. If earnings growth remains at roughly its historical average of 5%, Chen argues, it is almost mathematically impossible for bonds to beat stocks over a 40-year forecast horizon.
Andrew Ang and Xioyang Zhang conclude that the ERP is relatively stable over time. They decompose firms' future earnings into those associated with a perpetual, no-growth component and a component associated with future growth opportunities. This analysis shows that changes in growth opportunities, rather than in the no-growth component, explain the vast bulk of the variation in the P/E.
Jeremy Siegel looks back in history to the founding of the U.S. to emphasize continuities in the numbers that underlie the historical returns on equities and, thus, estimates of the equity risk premium. He shows that the two recent bear markets have not greatly affected the historical risk premium when measured over such a long time span. Siegel expects real stock returns of 6% to 7%, which translates to a risk premium of 5% to 6% (because real yields on Treasury bonds are only 1%).
Rajnish Mehra asks whether his original ground-breaking work, which predicted a very low ERP, has been vindicated by subsequent events. He proposes three sets of corrections to realized returns that make the "equity premium puzzle" literature, which Mehra originated, still relevant. Taken together, these corrections bring the equity risk premium within range of the numbers originally forecast by Mehra. One consequence of this analysis is that as the baby boom retires and raises the demand for bonds, it is possible that the ERP will be higher in the future.
The authors' estimates of the equity risk premium over intermediate-term U.S. Treasury bonds clustered around 4%, representing a much tighter range than was expressed in the 2001 forum. While this estimate is lower than the historically realized premium, it should be encouraging to investors who have suffered through more than a decade of bear markets and who may now worry that they missed their chance to invest profitably in equities.
Laurence B. Siegel
Research Director
Research Foundation of CFA Institute
4 of 4 people found the following review helpful
Format:Paperback|Amazon Verified Purchase
The term equity risk premium refers to the reward that investors hope to earn by investing in risky stocks rather than in safer securities like government bonds. "Hope" is the critical word here. Finance theory says that equity investors should on average receive higher returns than government bond investors -- i.e., they should be rewarded on average for taking greater risks. Unfortunately, investing is an uncertain science, and theory and reality don't always agree. During periods of a decade or two -- and sometimes even longer -- stocks occasionally have generated lower returns than bonds.
Will stocks provide higher returns than bonds in the future? If so, how much higher? These two questions are extremely important, and yet few people ask them. The demise of traditional corporate pension funds is one of the great tragedies of the late 20th Century. Workers who previously could count on secure pensions from their employers now find themselves cast adrift, managing their own retirement funds, but without a compass to guide them. Earning reasonable returns -- and, at the same time, minimizing losses -- can have a huge effect on their standards of living in retirement.
This book was written by professionals for professionals and, as a result, will be hard reading for some investors. Yet I'd encourage those who are at least familiar with investing terminology to give the book a try. There's a lot of wisdom here, and even on Wall Street wisdom is in surprisingly short supply.
What will this book tell you?
(a) That the future is unknowable. A table on page three shows estimates of the equity risk premium made ten years ago. Those estimates varied wildly -- from 0% to 7% per year -- and yet the actual result was worse than even the most pessimistic estimate. For the ten years ending in 2011, American equities had lower returns than Treasury bonds.
(b) That safety today may come at a high cost -- i.e., very low returns -- but that risky assets such as stocks may not offer as high potential returns as they usually have in the past.
(c) That averages are not outcomes. While taking risks on average should pay off, they won't always pay off. A pond may have an average depth of only twelve inches, yet it's still possible to drown.
In other words, the book's message is that we live in an uncertain world -- that you need to pay attention, and to think. This book will help you do both.
Will stocks provide higher returns than bonds in the future? If so, how much higher? These two questions are extremely important, and yet few people ask them. The demise of traditional corporate pension funds is one of the great tragedies of the late 20th Century. Workers who previously could count on secure pensions from their employers now find themselves cast adrift, managing their own retirement funds, but without a compass to guide them. Earning reasonable returns -- and, at the same time, minimizing losses -- can have a huge effect on their standards of living in retirement.
This book was written by professionals for professionals and, as a result, will be hard reading for some investors. Yet I'd encourage those who are at least familiar with investing terminology to give the book a try. There's a lot of wisdom here, and even on Wall Street wisdom is in surprisingly short supply.
What will this book tell you?
(a) That the future is unknowable. A table on page three shows estimates of the equity risk premium made ten years ago. Those estimates varied wildly -- from 0% to 7% per year -- and yet the actual result was worse than even the most pessimistic estimate. For the ten years ending in 2011, American equities had lower returns than Treasury bonds.
(b) That safety today may come at a high cost -- i.e., very low returns -- but that risky assets such as stocks may not offer as high potential returns as they usually have in the past.
(c) That averages are not outcomes. While taking risks on average should pay off, they won't always pay off. A pond may have an average depth of only twelve inches, yet it's still possible to drown.
In other words, the book's message is that we live in an uncertain world -- that you need to pay attention, and to think. This book will help you do both.
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