EQUITY RISK PREMIUMS—FORECASTING FUTURE RETURNS WITH EASE
Wish you could know where stocks will be in 10 years? Me too! I don’t think it’s possible. Still, people try. There’s a notion in academia about the equity risk premium (ERP). The ERP is, literally, the premium you get, expressed as a percentage over some supposed risk-free rate—like the 10-year US Treasury—from holding stocks. Some folks use the T-bill rate. Either way—same basic concept.
And there’s nothing wrong with that! It’s true—most often investors are rewarded long-term for taking extra volatility risk (done right). Since 1926, the average annualized ERP (using 10-year Treasuries) has been 4.4 percent—Treasuries have annualized 5.3 percent, and the S&P 500 9.7 percent1
—a huge spread! And theoretically, investors should
be rewarded for suffering through stock market swings. (Although, they hate the volatility. And the more the volatility, the more they hate it when they rationally should love it since, in the long run, they usually get paid handsomely for it.) If you weren’t likely to get higher reward for higher risk, why would anyone want the higher risk—whether measured by volatility or otherwise?
The problem with ERPs is some academics try to model future ERPs—predicting future stock returns. Bunk. I’ve never seen any ERP model stand up to historical back-testing. Not one! Yet, every year, we get a new wave of them.
Long-Distant Future Supply
When I say future, I mean most ERPs attempt forecasting ...