|
PureBytes Links
Trading Reference Links
|
While we're on the subject of stock market returns, Here's a link to the much
talked about Bernstein and Arnott paper. This paper is a keeper because it
summarizes a lot of financial and economic history as well as identifying the
stock market's "risk premium":
short link:
http://makeashorterlink.com/?I35E237B1
full link:
http://papers.ssrn.com/sol3/delivery.cfm/SSRN_ID296854_code020115510.pdf?abstra
ctid=296854
What Risk Premium is 'Normal'?
ROBERT D. ARNOTT
First Quadrant Corp. - General
PETER L. BERNSTEIN
Peter L. Bernstein, Inc. - General; Journal of Portfolio Management - General
-------------------------------------------------------------------------------
-
January 10, 2002
Abstract:
We are in an industry that thrives on the expedient of forecasting the future
by extrapolating the past. As a consequence, investors have grown accustomed to
the idea that stocks "normally" produce an 8% real return and a 5% risk premium
over bonds, compounded annually over many decades. Why? Because long-term
historical returns have been in this range, with impressive consistency.
Because investors see these same long-term historical numbers, year after year,
these expectations are now embedded into the collective psyche of the
investment community.
Both figures are unrealistic from current market levels. Few have acknowledged
that an important part of the lofty real returns of the past has stemmed from
rising valuation levels and from high dividend yields which have since
diminished. As this article will demonstrate, the long-term forward-looking
risk premium is nowhere near the 5% of the past; indeed, it may well be
near-zero today, perhaps even negative. Credible studies, in the US and
overseas, are now challenging this flawed conventional view, in well-researched
studies by Claus and Thomas [2001] and Fama and French [2000, Working Paper],
to name just two. Similarly, the long-term forward-looking real return from
stocks is nowhere near history's 8%. Our argument will show that, barring
unprecedented economic growth or unprecedented growth in earnings as a
percentage of the economy, real stock returns will probably be roughly 2-4%,
similar to bonds. Indeed, even this low real return figure assumes that current
near-record valuation levels are "fair," and likely to remain this high in the
years ahead. "Reversion to the mean" would push future real returns lower
still.
Furthermore, if we examine the historical record, neither the 8% real return
nor the 5% 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). Should investors require an 8% real return, or should a 5%
risk premium be necessary to induce an investor to bear stock market risk?
These returns and risk premiums are so grand that investors should perhaps have
bid them away a long time ago - indeed, they may have done so in the immense
bull market of 1982-1999.
Intuition suggests that investors should not require such outsize returns, and
the historical evidence supports this view. This is a topic meriting careful
exploration. After all, according to the Ibbotson data, investors earned 8%
real returns over the past 75 years, and stocks have outpaced bonds by nearly
5% over the past 75 years. So, why shouldn't investors have expected these
returns in the past and why shouldn't they continue to do so? Expressed in a
slightly different way, we examine two questions. First, can we derive an
objective estimate of what investors should have had good reasons to have
expected in the past? And, why should we expect less in the future than we've
earned in the past?
The answers to both questions lie in the difference between the observed excess
return and the prospective risk premium, two fundamentally different concepts
that unfortunately carry the same label, "risk premium." If we distinguish
between past excess returns and future expected risk premiums, it is not at all
unreasonable that the future risk premiums should be different from past excess
returns.
This is a complex topic, requiring several careful steps to evaluate correctly.
To gauge the risk premium for stocks relative to bonds, we need an expected
real stock return and an expected real bond return. To gauge the expected real
bond return, we need both bond yields and an estimate of expected inflation
through history. To gauge the expected real stock return, we need both stock
dividend yields and an estimate of expected real dividend growth. Accordingly,
we go through each of these steps, in reverse order, to form the building
blocks for the final goal: an estimate of the objective, forward-looking equity
risk premium, relative to bonds, through history.
------------------------ Yahoo! Groups Sponsor ---------------------~-->
4 DVDs Free +s&p Join Now
http://us.click.yahoo.com/pt6YBB/NXiEAA/MVfIAA/zMEolB/TM
---------------------------------------------------------------------~->
To unsubscribe from this group, send an email to:
realtraders-unsubscribe@xxxxxxxxxxxxxxx
Your use of Yahoo! Groups is subject to http://docs.yahoo.com/info/terms/
|