Just Released: Rethinking the Equity Risk Premium
Ten years ago a number of financial industry leaders met for a deep dive into the equity risk premium. Because of the importance of this topic, the Research Foundation of CFA Institute has now done a second deep dive with its Rethinking the Equity Risk Premium monograph, which includes the opinions of such luminaries as Roger G. Ibbotson, Clifford Asness, Robert D. Arnott, Jeremy J. Siegel, and Rajnish Mehra (all apologies to the other wonderful contributors).
A decade ago the bedrock financial topic of the equity risk premium inspired a diversity of opinions, and it is clear from the update that robust disagreement still exists. Ibbotson addresses this very point in the lead-off piece in Rethinking the Equity Risk Premium.
Yet, despite the divergence of opinion four general methods emerge for estimating the equity risk premium:
- A decomposition approach whereby the equity risk premium is broken into individual components, with those components then being estimated.
- A historical return differential approach comparing long-term equity index returns to the long-term returns of some asset considered to be a proxy for a risk-free asset. One alternative approach considers comparing the long-term earnings yield of a broad market index to the long-term yield of a risk-free proxy.
- Utilizing econometric techniques to estimate the components of the equity risk premium.
- A form of arbitrage thinking is used to estimate the equity risk premium.
Among the expert commentators, each agreed the equity risk premium varies over time rather than staying at a monolithic fixed level. Two camps have formed around using historical data: some, like Ibbotson, pull data starting at January 1926, others evaluate the equity risk premium over much longer periods of time (e.g., 1802 to 2011).
The lack of consensus among the contributors to Rethinking the Equity Risk Premium is actually a strength as readers get a robust continuum of carefully considered ideas, which makes examining one’s own ideas about the equity risk premium easier.
Given the admonition that the equity risk premium is variable over time, it may seem spurious to then take a look at the experts’ consensus estimates for the expected equity risk premium; however, I am certain that you are as curious as I was to know their estimates.
At the first gathering in 2001, the range of equity risk premium estimates was 0.0% to 7.0%, with a mean of just under 4.0%. At the time several contributors clearly felt that equities were still considerably overvalued relative to risk-free assets, as reflected by their expectations of a 0.0% equity risk premium.
In 2011 the range of equity risk premium estimates was 2.5% to 6.0%, centered around 3.25%. Clearly expectations for the equity risk premium have narrowed.
In conclusion, if you would like greater insight, mental framing, and access to considerate research about one of the most important topics in investing, Rethinking the Equity Risk Premium is well worth your time.