New articles ask us to ‘rethink the equity risk premium’

BVWireIssue #114-3
March 21, 2012

This week, London’s Economist ran an article that analyzes the history of the equity risk premium and asks, “What will the future reward for equity investors be?” The first step is to define the ERP more precisely, say the authors of “Shares and shibboleths: How much should people get paid for investing in the stockmarket?”  To do this, the article cites a series of papers published just last year by the Research Foundation of the CFA Institute entitled: “Rethinking the Equity Risk Premium.” The abstract states:

In 2001, a small group of academics and practitioners met to discuss the equity risk premium. 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.

More on the ERP. “In retrospect it looks as though the circumstances of the times, rather than the immutable laws of finance, may have been responsible for the size of the premium,” says a companion piece to the Economist’s first article. In “Too Much Risk, Not Enough Reward,” the authors state:

In recent years the premium seems to have evaporated. The Tokyo stock market is 75% below the peak it reached at the end of 1989. Treasury bonds easily outperformed American equities over the ten years to the end of 2011. The addiction to equities may itself have been part of the reason for the premium’s decline.  

Speaking about European markets, the article concludes: “Equities may offer better future returns than government bonds (which were selling off this week), but a reasonable estimate of the premium is only four percentage points a year,” which would be “only a little below the long-term average for America.”

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