3.5% Equity Risk Premium

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watchnerd
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3.5% Equity Risk Premium

Post by watchnerd »

I thought this was interesting:
Concluding remarks
This chapter has built on our estimates of the equity risk premium in order to look to the future. We use a building block approach to decompose past returns. After adjusting for non-repeatable factors that favored equities in the past, we infer that investors can expect an equity premium (relative to bills) of around 31⁄2% on a geometric mean basis and, by implication, an arithmetic mean premium of approximately 5%. We have also examined risk premiums for fixed-income investing – both the maturity premium and (in less detail) the credit premium.

From:

Credit Suisse Global Investment Returns Yearbook 2023 Summary Edition

PDF download on this page:

https://www.credit-suisse.com/about-us- ... 02302.html
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Re: 3.5% Equity Risk Premium

Post by muffins14 »

Is risk-free usually equal to inflation, so equity is 3.5% real-return?
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Re: 3.5% Equity Risk Premium

Post by watchnerd »

muffins14 wrote: Fri Mar 31, 2023 4:24 pm Is risk-free usually equal to inflation, so equity is 3.5% real-return?
The risk free rate might be a negative real yield.
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Re: 3.5% Equity Risk Premium

Post by ivgrivchuck »

muffins14 wrote: Fri Mar 31, 2023 4:24 pm Is risk-free usually equal to inflation, so equity is 3.5% real-return?
The most commonly used risk-free rate is a ten year treasury bond.

The equity risk premium goes on top of that.

Historically 10y treasury has yielded more than inflation...
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Re: 3.5% Equity Risk Premium

Post by whodidntante »

Keep in mind as you read this the company who wrote it failed. Well, unless you consider rescue and takeover a great success.
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Re: 3.5% Equity Risk Premium

Post by comeinvest »

ivgrivchuck wrote: Fri Mar 31, 2023 11:32 pm
muffins14 wrote: Fri Mar 31, 2023 4:24 pm Is risk-free usually equal to inflation, so equity is 3.5% real-return?
The most commonly used risk-free rate is a ten year treasury bond.

The equity risk premium goes on top of that.

Historically 10y treasury has yielded more than inflation...
The OP's citation says "relative to bills". 10-year bonds are not bills.
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Re: 3.5% Equity Risk Premium

Post by watchnerd »

comeinvest wrote: Fri Mar 31, 2023 11:49 pm
ivgrivchuck wrote: Fri Mar 31, 2023 11:32 pm
muffins14 wrote: Fri Mar 31, 2023 4:24 pm Is risk-free usually equal to inflation, so equity is 3.5% real-return?
The most commonly used risk-free rate is a ten year treasury bond.

The equity risk premium goes on top of that.

Historically 10y treasury has yielded more than inflation...
The OP's citation says "relative to bills". 10-year bonds are not bills.
I thought it was always vs T-bills in CAPM based models.
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Re: 3.5% Equity Risk Premium

Post by watchnerd »

whodidntante wrote: Fri Mar 31, 2023 11:43 pm Keep in mind as you read this the company who wrote it failed. Well, unless you consider rescue and takeover a great success.
The research dweebs probably weren't in the trading / risk management department, though.
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Re: 3.5% Equity Risk Premium

Post by dcabler »

watchnerd wrote: Sat Apr 01, 2023 1:11 am
whodidntante wrote: Fri Mar 31, 2023 11:43 pm Keep in mind as you read this the company who wrote it failed. Well, unless you consider rescue and takeover a great success.
The research dweebs probably weren't in the trading / risk management department, though.
Yep - and these particular research dweebs have been doing this for a very long time. "Triumph of the Optimists" is still one of my favorites.

Perhaps the crisis will prompt them to making the full version of their yearbook available to everybody as they did in the past. One can dream...

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Re: 3.5% Equity Risk Premium

Post by dcabler »

watchnerd wrote: Sat Apr 01, 2023 12:52 am
comeinvest wrote: Fri Mar 31, 2023 11:49 pm
ivgrivchuck wrote: Fri Mar 31, 2023 11:32 pm
muffins14 wrote: Fri Mar 31, 2023 4:24 pm Is risk-free usually equal to inflation, so equity is 3.5% real-return?
The most commonly used risk-free rate is a ten year treasury bond.

The equity risk premium goes on top of that.

Historically 10y treasury has yielded more than inflation...
The OP's citation says "relative to bills". 10-year bonds are not bills.
I thought it was always vs T-bills in CAPM based models.
I do recall that vineviz has made the argument for long term TIPS as the risk free asset for long term investors...

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Re: 3.5% Equity Risk Premium

Post by Valuethinker »

watchnerd wrote: Sat Apr 01, 2023 1:11 am
whodidntante wrote: Fri Mar 31, 2023 11:43 pm Keep in mind as you read this the company who wrote it failed. Well, unless you consider rescue and takeover a great success.
The research dweebs probably weren't in the trading / risk management department, though.
Precisely.

Dimson Marsh Staunton are academics. CS has sponsored this product. It's kind of an industry bible.

The failings of Credit Suisse as an investment bank are entirely incidental. It's like when Barclays (now those indices are with Blackrock, I believe) took over some of the bond indices that Lehman published when it went broke.
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Re: 3.5% Equity Risk Premium

Post by NiceUnparticularMan »

Personally, I think this part is something a lot of people here would benefit from understanding:
There is a clear relationship between the
current real interest rate and subsequent real
returns for both equities and bonds. Regression
analysis of real interest rates on real equity and
bond returns confirms this, yielding highly
significant coefficients. Note also that in every
band depicted in Figure 50, equities provided a
higher return than bonds.

When real interest rates are low, expected
future risky-asset returns are also lower.
However, during periods when real interest
rates fall unexpectedly, this will tend to provide
an immediate boost to asset prices and hence
returns, even though prospective returns will
have been lowered.
I am thinking of people who looked at rates on TIPS dropping into negative territory and argued that meant it was a bad idea to be holding TIPS (presumably versus stocks and nominal bonds). Or generally people who looked at negative rates on TIPS and implicitly argued that had no implications for things like safe withdrawal rates from standard stock/bond portfolios expressed as a percentage of current portfolio value.

None of what is in those paragraphs is really controversial. When real rates drop like that, risky stock and bond prices are going to go up, but their prospective real returns have gone down. This means there is no necessary change in their relative advantage over TIPS, and also that they are very likely less capable of sustaining a given percentage withdrawal.

I really wish more people here understood all that.
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Re: 3.5% Equity Risk Premium

Post by nisiprius »

...After adjusting for non-repeatable factors that favored equities in the past...
Sounds like there's a lot of judgement hidden in that aside. How much of it is subjective judgement?

Much of the long-term return of the stock market is nothing but non-repeatable factors in the past.

I agree with the idea, being something of an equities skeptic. But if you are going to throw out non-repeatable factors that favored equities in the past, why not throw out non-repeatable factors that hurt them in the past, too? Of course, people really do this--for example, when they choose to consider only international stock data post World War II, on the basis that, well, you know, that shouldn't count. People love to quote the "last fifty years" data rather than the "since 1900" data.
Last edited by nisiprius on Fri Apr 14, 2023 6:39 am, edited 1 time in total.
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Re: 3.5% Equity Risk Premium

Post by NiceUnparticularMan »

By the way, there is also a very interesting discussion of generational experiences. At a high level, real equity return averages have been marching down for more recent cohorts, but the "golden age" of bonds offset that somewhat and kept the returns on something like a 60:40 portfolio from dropping as much as the returns on just equities.

But to the extent that "golden age" involved dropping interest rates on bonds, it really cannot continue forever--and didn't. And so the forward-looking prospects for bonds, while somewhat improved due to the interest rate increases recently, are still significantly lower than the experience of those who benefited from the "golden age".

These again are not really controversial points, and it leads to the following conclusion:
Generation Z (born 1997–2012) faces a
different future. The block on the right of the
chart uses current long bond yields to indicate
future real bond returns and adds our estimated
equity premium to make a projection of real equity
returns for the next generation.

Expected equity returns are lower, although not
very different from those enjoyed by Millennials.
Prospective bond returns are much lower. Finally,
the balanced portfolio now offers a risky return of
around 3% in real terms – appreciably lower
than the real return enjoyed by the previous
three generations.
These are just "expected" returns so things could be better OR worse than this. But generally this is a very, very plausible "central" estimate, that a combination of low risk-free returns and a modest equity risk premium will mean that balanced portfolios return a lot less in real terms going forward than they did for recent older generations.

Which is another thing I wish more people here understood. So many common arguments here are essentially anecdotal in nature--backtesting said this portfolio worked for prior cohorts, historical studies say this was a safe withdrawal rate from this portfolio, I did such and such and it worked well for me, and so on.

But there are very, very good reasons to believe that to the extent those anecdotes implicitly depend on the higher risk-free rates of the past, they are not projectable into a future where risk-free rates are very likely to be lower than they were in the past.
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Re: 3.5% Equity Risk Premium

Post by nisiprius »

Yes to all that, and yet I believe that I am listing these in order of reliability:

a) Things will change, but we just don't know which way. (Most reliable)

b) Things will stay the same.

c) Things will change, and we know in which direction.

d) Things will change, and we know in which direction, and by how much.

I've read that, for weather, the "persistence prediction," specifically "tomorrow's weather will be the same as today's," is about 70% accurate.
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Re: 3.5% Equity Risk Premium

Post by NiceUnparticularMan »

nisiprius wrote: Fri Apr 14, 2023 6:43 am Yes to all that, and yet I believe that I am listing these in order of reliability:

a) Things will change, but we just don't know which way. (Most reliable)

b) Things will stay the same.

c) Things will change, and we know in which direction.

d) Things will change, and we know in which direction, and by how much.

I've read that, for weather, the "persistence prediction," specifically "tomorrow's weather will be the same as today's," is about 70% accurate.
Personally, I think for both long-term climate and long-term financial market projections, the probability of (b) is 0%. The history of both is that things change over time. Of course on a scale of a day, usually things don't change much (although some days in the financial markets have at least help trigger significant structural changes). But on a scale of, say, 10+ years, structural change in the financial markets is not only possible but inevitable.

A modified version of (b) would be something like that we know that things will not change by much from the last N years to the next N years. I would suggest that as N gets bigger, that sort of proposition is converging on (d) in that although it technically is not calling the direction of change, it is putting a small range on the magnitude of change, which grows increasingly unlikely as you assume more time for change to occur.
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Re: 3.5% Equity Risk Premium

Post by Chadnudj »

NiceUnparticularMan wrote: Fri Apr 14, 2023 8:09 am
nisiprius wrote: Fri Apr 14, 2023 6:43 am Yes to all that, and yet I believe that I am listing these in order of reliability:

a) Things will change, but we just don't know which way. (Most reliable)

b) Things will stay the same.

c) Things will change, and we know in which direction.

d) Things will change, and we know in which direction, and by how much.

I've read that, for weather, the "persistence prediction," specifically "tomorrow's weather will be the same as today's," is about 70% accurate.
Personally, I think for both long-term climate and long-term financial market projections, the probability of (b) is 0%. The history of both is that things change over time. Of course on a scale of a day, usually things don't change much (although some days in the financial markets have at least help trigger significant structural changes). But on a scale of, say, 10+ years, structural change in the financial markets is not only possible but inevitable.

A modified version of (b) would be something like that we know that things will not change by much from the last N years to the next N years. I would suggest that as N gets bigger, that sort of proposition is converging on (d) in that although it technically is not calling the direction of change, it is putting a small range on the magnitude of change, which grows increasingly unlikely as you assume more time for change to occur.
I think nisiprius's point with B was more that backtested data (like the Trinity Study, the long term 6-7% real return of the S&P 500, etc.) can be trusted as a forecast for the future, and thus "things will stay the same" (or, perhaps more precisely, "the future over the long term will behave much like the past did"). Now, the components of the S&P 500 may shift dramatically, and indeed they have previously from when General Electric was one of the biggest companies by market cap in the world, and other factors may blow the economy in different directions, but B posits that the best practices of the past -- namely Boglehead ones of dollar cost averaging into and holding low cost index fund portfolios allocated to an appropriate equity-fixed income proportion and rebalancing -- are likely to continue working into the future.
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Re: 3.5% Equity Risk Premium

Post by seajay »

nisiprius wrote: Fri Apr 14, 2023 6:23 am
...After adjusting for non-repeatable factors that favored equities in the past...
Sounds like there's a lot of judgement hidden in that aside. How much of it is subjective judgement?

Much of the long-term return of the stock market is nothing but non-repeatable factors in the past.

I agree with the idea, being something of an equities skeptic. But if you are going to throw out non-repeatable factors that favored equities in the past, why not throw out non-repeatable factors that hurt them in the past, too? Of course, people really do this--for example, when they choose to consider only international stock data post World War II, on the basis that, well, you know, that shouldn't count. People love to quote the "last fifty years" data rather than the "since 1900" data.
I suspect businesses will continue to make 10% type profits, and that investors will continue to bid up share prices to around twice book value - be content with 5% profits. And as one investor comes to sell their share(s), another with surplus capital will be content to buy (share prices broadly rising with inflation). The 'non repeatable' factors will distort the supply/demand (prices) in a unpredictable manner, those fortunate enough to have bought at a trough time, sold at a peak time will do very well, whilst those that bought at a peak, sold at a trough may very well do as, if not less well than had they just deposited cash for interest. The majority in between will generally be content with the broader average of share prices that broadly rise with inflation along with dividends on top.
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Re: 3.5% Equity Risk Premium

Post by JackoC »

nisiprius wrote: Fri Apr 14, 2023 6:23 am
...After adjusting for non-repeatable factors that favored equities in the past...
Sounds like there's a lot of judgement hidden in that aside. How much of it is subjective judgement?

Much of the long-term return of the stock market is nothing but non-repeatable factors in the past.

I agree with the idea, being something of an equities skeptic. But if you are going to throw out non-repeatable factors that favored equities in the past, why not throw out non-repeatable factors that hurt them in the past, too? Of course, people really do this--for example, when they choose to consider only international stock data post World War II, on the basis that, well, you know, that shouldn't count. People love to quote the "last fifty years" data rather than the "since 1900" data.
If they are referring to equity valuations being generally higher now than past, which valuation increase created a tailwind for equity returns, that should be excluded from an estimate of expected return now. It's not 'non repeatable' per se, valuations could continue to go up, or go down. Saying the future expected value of valuation is higher than now though is aggressive. And that's one of two connected biases in assuming past return as the benchmark for expected return. Past return a) included the tailwind from valuations rising b) it was boosted by the higher dividend yield to start with than now.

On 3.5% 'ERP', earlier posts went back and forth on what the 'riskless asset' really is, T-bill, 5yr note (one past study said it's behaved statistically most like what the RFA is supposed to in the CAPM), long TIPS? But whatever *should* be called the RFA, if these authors are benchmarking to T-bills then 3.5% ERP is in the same ballpark as 3.5% real expected return because T-bill real return has been in the ballpark of zero. Past data includes a significant realized term premium (investors got a premium over credit *and* duration riskless investment by taking duration risk, though that doesn't have to be true and yield curve models recently imply a smaller, or even negative expected term premium vs. average realized historical).

Is 3.5% expected real pre tax return realistic for stocks? I think so, roughly. Two other ways to estimate it:
1. price of a stock S=Div/(r-g) S the stock price, r the return, and g the dividend growth rate, or IOW r=S/Div+g, the return the perpetual payout of the dividend plus dividend growth.

But dividend growth comes from earnings growth comes from return. Assume in equilibrium the real expected return on the stock is the return on capital of the company.
So restate the first equation as S= p*E/(r-(1-p)*r), where p is the payout ratio, ie Div=p*E, div growth rate is (1-p)*r
Therefore r=E/S
Let's say we take a smoothed E/S like 1/CAPE. 3.5% would mean CAPE~29, S&P CAPE is a little higher, though global a few points lower.

2. Same equation is turned around to say E[r]=div yield+real div growth. VT's div yield is right around 2%. In the US in 20th century real div grew around 1.5% though GDP grew low 3's. Now world GDP growth trend is maybe low-mid 3's. Would come out something like 3.5, with maybe a small add on for slight decrease in net dilution rate due to more buybacks now (there's no evidence it's dramatic).

Starry eyed optimistic that I am, I assume 4% real pre tax expected return for stocks.
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Re: 3.5% Equity Risk Premium

Post by NiceUnparticularMan »

Chadnudj wrote: Fri Apr 14, 2023 8:29 am I think nisiprius's point with B was more that backtested data (like the Trinity Study, the long term 6-7% real return of the S&P 500, etc.) can be trusted as a forecast for the future, and thus "things will stay the same" (or, perhaps more precisely, "the future over the long term will behave much like the past did").
I'm not sure that is exactly what was intended with (b), but if so then my comments very much apply. Meaning I think the proposition phrased that way is very unreliable, and should be down close to (d) in terms of unreliability.

And actually, I think phrased that way, it is just really unlikely to be true. There are very good explanations as to why real returns on both equities and bonds would be drifting down over time (subject of course to shorter-term variation), which in fact would just be a continuation of a trend that has been happening for centuries.

So to me, the idea of projecting them out as staying level instead is particularly unlikely to be a good projection.
but B posits that the best practices of the past -- namely Boglehead ones of dollar cost averaging into and holding low cost index fund portfolios allocated to an appropriate equity-fixed income proportion and rebalancing -- are likely to continue working into the future.
That is mixing together a lot of issues.

I would agree the general concept of saving for retirement early and often by investing in diversified risky assets remains a good idea. The most efficient way to do that, though, is one of the things that has evolved over time. That is true in part because new types of assets that are consistent with that approach have been created, costs have evolved (usually lower, which is good), and so on.

I also agree that using very-low-risk assets in combination with a portfolio of risky assets to manage certain important forms of risks, particularly sequence of real returns risk, makes sense for retirement savers. I note that the available fixed income assets are also something that has evolved a lot over time, and today different people often have different options available to them. So this is definitely an area where efficient implementation rationally depends on the options available to you at the time.

I do not agree the idea of adopting a single unchanging equity-fixed income proportion and rebalancing to that target ever had a very good foundation. This was a sort of modification of modern portfolio theory except it unnecessarily confused risky fixed income assets with very low risk fixed income assets, and in reasonable models those two categories of fixed income have very different purposes. It also is typically argued for using a very unrealistic model of investor psychology.

However, it is true that there are a lot of people here who argue that a static approach involving the sorts of assets available circa 1990 is really good and all you need and so forth. As evidence, they typically cite a combination of their own anecdotal experience, backtesting of some sort, and maybe something Bogle once said.

This is precisely the sort of argument I was referencing above. The anecdotes, including the backtesting, these people are offering typically implicitly depend on the good results for nominal USD bonds that happened during the era of decreasing interest rates, aka the "golden age" of bonds. Rationally, people should understand that cannot possibly be sustained. Rationally, people should also understand that decline in interest rates means risk-adjusted real rates on bonds going forward are likely to be much lower. Rationally, people should understand that very likely means risk-adjusted real rates on equities are also likely to be lower.

OK, so using nisiprius's framework, I am very much arguing that some form of (c) should be put well ahead of (b). I don't think we can "know" these things, but I do think there are very good reason to believe that the real returns on risky assets like stocks and risky bonds will very likely be lower over the next, say, 30 years than they were over the last 30 years. And I think people who one way or another insist it is instead likely they will be around the same do not have a reliable argument for that sort of assumption.

And I also think people who ignore the evolution of available assets and say a combination of whatever was already available circa 1990 do not have a very good argument for doing that.
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Re: 3.5% Equity Risk Premium

Post by David Jay »

NiceUnparticularMan wrote: Fri Apr 14, 2023 9:16 amI do think there are very good reason to believe that the real returns on risky assets like stocks and risky bonds will very likely be lower over the next, say, 30 years than they were over the last 30 years.
Which is, in fact, a “C” statement. You have a strongly held belief that you know the direction of the change.
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Re: 3.5% Equity Risk Premium

Post by watchnerd »

dcabler wrote: Fri Apr 14, 2023 5:39 am
watchnerd wrote: Sat Apr 01, 2023 12:52 am
comeinvest wrote: Fri Mar 31, 2023 11:49 pm
ivgrivchuck wrote: Fri Mar 31, 2023 11:32 pm
muffins14 wrote: Fri Mar 31, 2023 4:24 pm Is risk-free usually equal to inflation, so equity is 3.5% real-return?
The most commonly used risk-free rate is a ten year treasury bond.

The equity risk premium goes on top of that.

Historically 10y treasury has yielded more than inflation...
The OP's citation says "relative to bills". 10-year bonds are not bills.
I thought it was always vs T-bills in CAPM based models.
I do recall that vineviz has made the argument for long term TIPS as the risk free asset for long term investors...

Cheers
Hypothetically, I'm aligned with that and it's what I personally practice.

But TIPS are not what existing valuation / pricing models are based on.
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Re: 3.5% Equity Risk Premium

Post by watchnerd »

NiceUnparticularMan wrote: Fri Apr 14, 2023 6:18 am Personally, I think this part is something a lot of people here would benefit from understanding:
There is a clear relationship between the
current real interest rate and subsequent real
returns for both equities and bonds. Regression
analysis of real interest rates on real equity and
bond returns confirms this, yielding highly
significant coefficients. Note also that in every
band depicted in Figure 50, equities provided a
higher return than bonds.

When real interest rates are low, expected
future risky-asset returns are also lower.
However, during periods when real interest
rates fall unexpectedly, this will tend to provide
an immediate boost to asset prices and hence
returns, even though prospective returns will
have been lowered.
I am thinking of people who looked at rates on TIPS dropping into negative territory and argued that meant it was a bad idea to be holding TIPS (presumably versus stocks and nominal bonds). Or generally people who looked at negative rates on TIPS and implicitly argued that had no implications for things like safe withdrawal rates from standard stock/bond portfolios expressed as a percentage of current portfolio value.

None of what is in those paragraphs is really controversial. When real rates drop like that, risky stock and bond prices are going to go up, but their prospective real returns have gone down. This means there is no necessary change in their relative advantage over TIPS, and also that they are very likely less capable of sustaining a given percentage withdrawal.

I really wish more people here understood all that.
I actually thought everyone understood this.

When economists talk about asset bubbles, it's related.
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Re: 3.5% Equity Risk Premium

Post by NiceUnparticularMan »

David Jay wrote: Fri Apr 14, 2023 9:25 am
NiceUnparticularMan wrote: Fri Apr 14, 2023 9:16 amI do think there are very good reason to believe that the real returns on risky assets like stocks and risky bonds will very likely be lower over the next, say, 30 years than they were over the last 30 years.
Which is, in fact, a “C” statement. You have a strongly held belief that you know the direction of the change.
Well, I didn't say I "know", I said I think there are very good reasons to believe it is very likely that will be the direction of change.

I tend to be careful about that sort of thing because I think it is important to understand the future is uncertain, it gets more uncertain the longer out you are looking, and so everything you say about the future should be probabilistic, and conditional on current information.

But sure, I think there are very good reasons to believe that it is more likely that the longstanding historic trend of real returns on risky assets declining will continue, versus halting or reversing. So I don't mind acknowledging that is basically arguing that (c) should be ranked ahead of (b), although again I would not actually use the phrasing in (c) to express that thought because I think that would be overstating the proposition in notable ways.
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Re: 3.5% Equity Risk Premium

Post by HanSolo »

watchnerd wrote: Fri Mar 31, 2023 4:22 pm I thought this was interesting:
Concluding remarks
This chapter has built on our estimates of the equity risk premium in order to look to the future. We use a building block approach to decompose past returns. After adjusting for non-repeatable factors that favored equities in the past, we infer that investors can expect an equity premium (relative to bills) of around 31⁄2% on a geometric mean basis and, by implication, an arithmetic mean premium of approximately 5%. We have also examined risk premiums for fixed-income investing – both the maturity premium and (in less detail) the credit premium.
From:

Credit Suisse Global Investment Returns Yearbook 2023 Summary Edition
Well then... it's interesting that the above matches my off-the-cuff, back-of-the-napkin guesstimate, one month ago, of what's going on in the minds of institutional investors (from another thread, in the context of why the crash of 2023, widely predicted by many pundits around the new year, hasn't happened):
HanSolo wrote: Sat Mar 11, 2023 1:52 pm My guess: there may be a longer-term estimate (e.g., in the minds of large institutional investors) of S&P fair value in the mid-5000s by end-of-decade, and the pundits think a 5% annualized gain from now until then is unacceptable to stock investors, so they think the market has to drop to levels where the annualized gain will be more like 10% (while still on target to reach the mid-5000s by end-of-decade). But if market participants, by and large, are OK with that 5% annualized return, then the market doesn't need to drop as much as the pundits expect.
The actionable thing (for me, anyway) is to stick to my target AA.
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Re: 3.5% Equity Risk Premium

Post by watchnerd »

My napkin math:

10 year equity risk premium of global equities vs 10 YR TIPS:

2.99% real

I expect US equities to be lower given valuations.
Last edited by watchnerd on Fri Apr 14, 2023 9:56 am, edited 1 time in total.
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Re: 3.5% Equity Risk Premium

Post by NiceUnparticularMan »

watchnerd wrote: Fri Apr 14, 2023 9:45 am
I really wish more people here understood all that.
I actually thought everyone understood this.

When economists talk about asset bubbles, it's related.
I agree at least most economists treat that as an uncontroversial concept.

What I find remarkable, and dangerous even, is the number of arguments made here which seem to depend on not understanding how this concept applies to risky stocks and bonds.

So if "everyone" is (most) economists, sure.

If "everyone" is posters here? Not so much.
Last edited by NiceUnparticularMan on Fri Apr 14, 2023 10:12 am, edited 1 time in total.
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Re: 3.5% Equity Risk Premium

Post by watchnerd »

NiceUnparticularMan wrote: Fri Apr 14, 2023 9:56 am

I agree at least most economists treat that as an uncontroversial concept.

What I find remarkable, and dangerous even, is the number of arguments made here which seem to depend on not understanding how this concept applies to risky stocks and bonds.

So if "everyone" is (most) economists, sure.

If "everyone" is posters here? Not so much.
Fair point.

And given the number of Boglehead forum posters who seem to have been shocked by recent bond fund behavior, I've concluded that Boglehead overall economic / financial literacy is lower than I thought.
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Re: 3.5% Equity Risk Premium

Post by watchnerd »

seajay wrote: Fri Apr 14, 2023 8:39 am And as one investor comes to sell their share(s), another with surplus capital will be content to buy (share prices broadly rising with inflation).
How well does this work with demographics being what they are?

One of the things that may have contributed to the long bull run was a giant cohort of Baby Boomers buying stocks in their retirement portfolios. Now instead of accumulating, they're withdrawing.

And the follow-on generations aren't as big relative to the rest of the population as the Baby Boomers were in their prime.

i.e. there may be fewer investors
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Re: 3.5% Equity Risk Premium

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NiceUnparticularMan wrote: Fri Apr 14, 2023 9:51 am
But sure, I think there are very good reasons to believe that it is more likely that the longstanding historic trend of real returns on risky assets declining will continue, versus halting or reversing.
When capital flows more easily (creating more capital access) than in centuries or decades past and there may be more surplus of it than capital than in centuries or decades past, it is not unreasonable to believe that that the capital supply : demand ratio is not as high, and thus returns may be muted.

I know for my family history the difference in the amount of excess capital available to invest between my grandfather, my father, and me is extraordinary.
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Re: 3.5% Equity Risk Premium

Post by JackoC »

David Jay wrote: Fri Apr 14, 2023 9:25 am
NiceUnparticularMan wrote: Fri Apr 14, 2023 9:16 amI do think there are very good reason to believe that the real returns on risky assets like stocks and risky bonds will very likely be lower over the next, say, 30 years than they were over the last 30 years.
Which is, in fact, a “C” statement. You have a strongly held belief that you know the direction of the change.
But the rub here is depends on what 'things' refers to in
a) Things will change, but we just don't know which way. (Most reliable)

c) Things will change, and we know in which direction.

If 'things' are valuation, earnings yields, div yields, bond yields, which we know will vary, but we adopt a) by assuming that their future expected value is today's value, then expected return is lower than past realized return. Because those yields are lower now than historical average. Applying a) directly to expected return by assuming expected return equals past geo-average realized return doesn't make much sense in general. It's only reasonable if current yield/valuation happens to be near the mean of what it was in the past, or more fundamentally the balance in supply and uses for capital is the same.

And as another part of NUM's post said, various research shows returns on capital in a multi-century declining trend. An example is Schmelzing's research on sovereign debt returns, he found a general downtrend since the 14th century. So I also favor a) in general but it can be trickier to define 'things' than the simple statement implies.

https://economics.rutgers.edu/downloads ... lzing/file
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Re: 3.5% Equity Risk Premium

Post by NiceUnparticularMan »

watchnerd wrote: Fri Apr 14, 2023 10:00 am And given the number of Boglehead forum posters who seem to have been shocked by recent bond fund behavior, I've concluded that Boglehead overall economic / financial literacy is lower than I thought.
Indeed. There were a lot of "but I thought bonds were for safety/I thought bonds move opposite to stocks" posts. This is a good example of not understanding what it means when stock and risky bond prices go up as real rates go down, and what will likely then happen to those asset prices if real rates go back up.

A bit of an aside, but my observation is part of the issue is for a very long time, people have been warning that as bond rates got lower and lower, that meant expected returns on bonds should get lower too. But then bond rates would go even lower still, bond price increases would add to bond returns, and other people would say the first group of people had just been crying wolf about bond returns.

Of course in the fable, the wolf actually did show up eventually. And so too here.

So shepherds can be blamed when they overstate their case, but so too can villagers be blamed for thinking if a risk hasn't materialized yet, that means it never will.
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Re: 3.5% Equity Risk Premium

Post by watchnerd »

JackoC wrote: Fri Apr 14, 2023 10:22 am And as another part of NUM's post said, various research shows returns on capital in a multi-century declining trend. An example is Schmelzing's research on sovereign debt returns, he found a general downtrend since the 14th century. So I also favor a) in general but it can be trickier to define 'things' than the simple statement implies.

https://economics.rutgers.edu/downloads ... lzing/file
I wonder if aging societies will reverse this by burning up excess free capital, creating scarcity and potential for better capital returns.

It's a situation we haven't had in prior history.
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Re: 3.5% Equity Risk Premium

Post by NiceUnparticularMan »

watchnerd wrote: Fri Apr 14, 2023 10:18 am
NiceUnparticularMan wrote: Fri Apr 14, 2023 9:51 am
But sure, I think there are very good reasons to believe that it is more likely that the longstanding historic trend of real returns on risky assets declining will continue, versus halting or reversing.
When capital flows more easily (creating more capital access) than in centuries or decades past and there may be more surplus of it than capital than in centuries or decades past, it is not unreasonable to believe that that the capital supply : demand ratio is not as high, and thus returns may be muted.

I know for my family history the difference in the amount of excess capital available to invest between my grandfather, my father, and me is extraordinary.
That is definitely a big part of it. And I'm not sure all Bogleheads understand how much things have been changing in many parts of the world with which they are not familiar. Like, things have changed a lot just in the US, but in recent decades in a lot of countries there has been an explosion in people and entities with capital they are looking to invest in global asset markets. And there is good reason to believe the global supply of assets in which to invest simply had not kept up with the supply of capital looking for an asset.

The other big thing is just that the world has gotten less and less risky for investors. People will cite recent events like the Russia-Ukraine war, but from an historic perspective, that is actually a great example of how even our wars today can prove to be way less disruptive to most assets.

All this explains why prices for risky assets would go up, both because of capital/asset supply issues and because of declining risk premiums. But that also means their expected returns would go down.
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Re: 3.5% Equity Risk Premium

Post by NiceUnparticularMan »

watchnerd wrote: Fri Apr 14, 2023 10:27 am I wonder if aging societies will reverse this by burning up excess free capital, creating scarcity and potential for better capital returns.

It's a situation we haven't had in prior history.
It is going to be "interesting", but I note that at least historically, the supply of productive assets in which to invest (or assets backed by production, like bonds) has been tied pretty tightly to the human labor supply. There are other factors of production, but in the end you needed plenty of people working to help produce monetizable goods or services.

So slower growth of working age populations would historically have implied slower growth of assets in which to invest, which would seem to suggest returns could stay low indefinitely.

That said, maybe AI will decouple productive assets from human labor supply in unprecedented ways. We've seen a little of that in manufacturing, of course, but the idea is that happening in a much broader way. In fact that's such a broad thought it is difficult to say much about what that might mean for financial markets, but at a minimum it could mean real consumption per capita exploding. Whether that would go disproportionately to people with large stock/bond portfolios before the explosion, who knows?
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Re: 3.5% Equity Risk Premium

Post by alex_686 »

dcabler wrote: Fri Apr 14, 2023 5:39 am
watchnerd wrote: Sat Apr 01, 2023 12:52 am
comeinvest wrote: Fri Mar 31, 2023 11:49 pm
ivgrivchuck wrote: Fri Mar 31, 2023 11:32 pm
muffins14 wrote: Fri Mar 31, 2023 4:24 pm Is risk-free usually equal to inflation, so equity is 3.5% real-return?
The most commonly used risk-free rate is a ten year treasury bond.

The equity risk premium goes on top of that.

Historically 10y treasury has yielded more than inflation...
The OP's citation says "relative to bills". 10-year bonds are not bills.
I thought it was always vs T-bills in CAPM based models.
I do recall that vineviz has made the argument for long term TIPS as the risk free asset for long term investors...

Cheers
The standard formulation of ERP is

Total Return = long term government bond + erp.

Now sure, you can decompose long term nominal bonds into real interest rates and expect inflation but why would you want to do so? (And there are reasons to do so, but it should be called out because it is mot the default presentation.)

I default to 10 year nominal bond. Vineviz has argued with me that it is actually empirically around 8ish years.
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Re: 3.5% Equity Risk Premium

Post by David Jay »

NiceUnparticularMan wrote: Fri Apr 14, 2023 10:42 am
watchnerd wrote: Fri Apr 14, 2023 10:27 am I wonder if aging societies will reverse this by burning up excess free capital, creating scarcity and potential for better capital returns.

It's a situation we haven't had in prior history.
It is going to be "interesting", but I note that at least historically, the supply of productive assets in which to invest (or assets backed by production, like bonds) has been tied pretty tightly to the human labor supply. There are other factors of production, but in the end you needed plenty of people working to help produce monetizable goods or services.

So slower growth of working age populations would historically have implied slower growth of assets in which to invest, which would seem to suggest returns could stay low indefinitely.

That said, maybe AI will decouple productive assets from human labor supply in unprecedented ways. We've seen a little of that in manufacturing, of course, but the idea is that happening in a much broader way. In fact that's such a broad thought it is difficult to say much about what that might mean for financial markets, but at a minimum it could mean real consumption per capita exploding. Whether that would go disproportionately to people with large stock/bond portfolios before the explosion, who knows?
Thirty years is along time:

Thirty years ago, I was recording my daughter's 7th birthday with a video camera that had a full-size VHS tape loaded into the side.
Thirty years ago I was driving a car with a carburetor.
Thirty years ago, I had a cassette player in my car.
Thirty years ago, I wrote company correspondence longhand and the secretary used the department's "word processor" create a letter.
Thirty years ago, I sent inter-company correspondence by FAX.
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Re: 3.5% Equity Risk Premium

Post by abc132 »

This is the kind of thread that usually causes people to underperform. It is interesting to look at but my guess is despite a high level of knowledge quite a few people will act in a way with negative expected value even on a risk vs reward basis. People are now fabricating a whole new set of concerns as if they are any more meaningful than the last set of concerns - which resulted in some fantastic returns. The lesson is not that returns will be fantastic but that the predictions are not particularly actionable.

Comparing 4% vs 7% a 3% premium means an expected value twice as big after 25 years. It is very unlikely that one will be able to benefit from timing the transition out of stocks based on a risk premium. The least risk is generally taken by picking a fixed AA or glidepath and transitioning over time without respect to predictions or risk premiums. Form a solid plan and ignore the noise.
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Re: 3.5% Equity Risk Premium

Post by CyclingDuo »

watchnerd wrote: Fri Apr 14, 2023 10:06 am
seajay wrote: Fri Apr 14, 2023 8:39 am And as one investor comes to sell their share(s), another with surplus capital will be content to buy (share prices broadly rising with inflation).
How well does this work with demographics being what they are?

One of the things that may have contributed to the long bull run was a giant cohort of Baby Boomers buying stocks in their retirement portfolios. Now instead of accumulating, they're withdrawing.

And the follow-on generations aren't as big relative to the rest of the population as the Baby Boomers were in their prime.

i.e. there may be fewer investors
Not sure I would agree about fewer - especially when we combine the size of Gen X, Gen Y, Gen Z, Gen Alpha, etc.

It's a bit odd, in terms of population numbers, how we count and label demographic groups. Suffice it to say, the parameters are a bit squishy.

•19 full years for the Baby Boomers from the inclusive years of 1946 - 1964

However...subsequent generations we scale back those numbers to a time frame that is a full 3 years shorter. No wonder the numbers are what they are since the subsequent generations' parameters are a full 18.75% shorter. :shock:

•16 years for Gen X from the inclusive years of 1965-1980
•16 years for Millennials from the inclusive years of 1981-1996
•16 years for Gen Z from from the inclusive years of 1997-2012
•Gen Alpha?

If we cut off the first three years of the Baby Boomer measuring stick of 1946, 1947, and 1948 that would make the numbers 10.9M smaller. If we cut off the last three years of the Baby Boomer measuring stick of 1964, 1963, and 1962 that would make the numbers 12.27M smaller. Likewise, if we went in the other direction and added three years onto either end of a subsequent generation...

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Re: 3.5% Equity Risk Premium

Post by 9-5 Suited »

dcabler wrote: Fri Apr 14, 2023 5:39 am
watchnerd wrote: Sat Apr 01, 2023 12:52 am I thought it was always vs T-bills in CAPM based models.
I do recall that vineviz has made the argument for long term TIPS as the risk free asset for long term investors...
Depending on the model I've seen anything ranging from the 6 month to the 10 year Treasury as the "risk free rate". But to me that's more of an academic concept, as a 6 month or 10 year Treasury is not "risk free" (as in it is not "without risk") to a given investor. So Vineviz is correct, but it's just a matter of theory vs. practice rather than a disagreement.

It's tough to argue that a duration-matched TIPS in a tax-advantaged account isn't the most free-of-risk asset for a given investor goal. It's immunized from price risk, reinvestment risk, inflation risk, default risk, and tax risk (mostly). The catch is you have to save a ton of money to fully fund a large savings goal with TIPS.
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Re: 3.5% Equity Risk Premium

Post by alex_686 »

9-5 Suited wrote: Fri Apr 14, 2023 12:10 pm
dcabler wrote: Fri Apr 14, 2023 5:39 am
watchnerd wrote: Sat Apr 01, 2023 12:52 am I thought it was always vs T-bills in CAPM based models.
I do recall that vineviz has made the argument for long term TIPS as the risk free asset for long term investors...
Depending on the model I've seen anything ranging from the 6 month to the 10 year Treasury as the "risk free rate". But to me that's more of an academic concept, as a 6 month or 10 year Treasury is not "risk free" (as in it is not "without risk") to a given investor. So Vineviz is correct, but it's just a matter of theory vs. practice rather than a disagreement.
But that is really not the point. The question is how much extra return do you need to chose risky equities over safer government bonds.

As such you want to compare apples to apples. You invest in equities for long term returns, not short term. Thus you want to compare to a government bond of a similar duration. We can debate if that period should be 10 years or 6, but you are not going to make a solid argument for 6 months.
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Re: 3.5% Equity Risk Premium

Post by 9-5 Suited »

alex_686 wrote: Fri Apr 14, 2023 12:19 pm
9-5 Suited wrote: Fri Apr 14, 2023 12:10 pm
dcabler wrote: Fri Apr 14, 2023 5:39 am
watchnerd wrote: Sat Apr 01, 2023 12:52 am I thought it was always vs T-bills in CAPM based models.
I do recall that vineviz has made the argument for long term TIPS as the risk free asset for long term investors...
Depending on the model I've seen anything ranging from the 6 month to the 10 year Treasury as the "risk free rate". But to me that's more of an academic concept, as a 6 month or 10 year Treasury is not "risk free" (as in it is not "without risk") to a given investor. So Vineviz is correct, but it's just a matter of theory vs. practice rather than a disagreement.
But that is really not the point. The question is how much extra return do you need to chose risky equities over safer government bonds.

As such you want to compare apples to apples. You invest in equities for long term returns, not short term. Thus you want to compare to a government bond of a similar duration. We can debate if that period should be 10 years or 6, but you are not going to make a solid argument for 6 months.
We're talking past each other I think. I'm indifferent to how practioniers of various mathematical models and formulas across the investment world want to construct the risk-free rate for the purpose of their generalizable models. I trust their expertise in that manner. I'm speaking from the perspective of investing practice for an individual. I consider the real-yield on a TIPS matched to my specific duration (when the money is needed) to be the risk-free rate for the purpose of assessing the baseline for my need to take equity risk. The 10-year Treasury would be an arbitrary standard that has nothing to do with me particularly.
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Re: 3.5% Equity Risk Premium

Post by NiceUnparticularMan »

David Jay wrote: Fri Apr 14, 2023 11:06 am Thirty years is along time:

Thirty years ago, I was recording my daughter's 7th birthday with a video camera that had a full-size VHS tape loaded into the side.
Thirty years ago I was driving a car with a carburetor.
Thirty years ago, I had a cassette player in my car.
Thirty years ago, I wrote company correspondence longhand and the secretary used the department's "word processor" create a letter.
Thirty years ago, I sent inter-company correspondence by FAX.
Indeed. I think of such long time horizons as "science fiction" territory. Which is not supposed to be reassuring--the 1982 movie Blade Runner was set in 2019. It was not exactly prophetic (not yet at least).
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Re: 3.5% Equity Risk Premium

Post by NiceUnparticularMan »

abc132 wrote: Fri Apr 14, 2023 11:24 amThe lesson is not that returns will be fantastic but that the predictions are not particularly actionable.
I agree that trying to shift around your asset allocation in response to models like this is unlikely to be helpful and could easily be harmful.

However, there are potential implications for things like savings rates and withdrawal rates that could be actionable.
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Re: 3.5% Equity Risk Premium

Post by secondopinion »

9-5 Suited wrote: Fri Apr 14, 2023 12:26 pm
alex_686 wrote: Fri Apr 14, 2023 12:19 pm
9-5 Suited wrote: Fri Apr 14, 2023 12:10 pm
dcabler wrote: Fri Apr 14, 2023 5:39 am
watchnerd wrote: Sat Apr 01, 2023 12:52 am I thought it was always vs T-bills in CAPM based models.
I do recall that vineviz has made the argument for long term TIPS as the risk free asset for long term investors...
Depending on the model I've seen anything ranging from the 6 month to the 10 year Treasury as the "risk free rate". But to me that's more of an academic concept, as a 6 month or 10 year Treasury is not "risk free" (as in it is not "without risk") to a given investor. So Vineviz is correct, but it's just a matter of theory vs. practice rather than a disagreement.
But that is really not the point. The question is how much extra return do you need to chose risky equities over safer government bonds.

As such you want to compare apples to apples. You invest in equities for long term returns, not short term. Thus you want to compare to a government bond of a similar duration. We can debate if that period should be 10 years or 6, but you are not going to make a solid argument for 6 months.
We're talking past each other I think. I'm indifferent to how practioniers of various mathematical models and formulas across the investment world want to construct the risk-free rate for the purpose of their generalizable models. I trust their expertise in that manner. I'm speaking from the perspective of investing practice for an individual. I consider the real-yield on a TIPS matched to my specific duration (when the money is needed) to be the risk-free rate for the purpose of assessing the baseline for my need to take equity risk. The 10-year Treasury would be an arbitrary standard that has nothing to do with me particularly.
The built-in duration that stocks carry exists regardless you care about it or not. The point is to obtain a number "after" adjusting for what can be explained by duration. You might not care and just use TIPS as you suggested, but then the question is whether the premium came from duration or equity risk.
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Re: 3.5% Equity Risk Premium

Post by NoRegret »

JackoC wrote: Fri Apr 14, 2023 8:59 am Let's say we take a smoothed E/S like 1/CAPE. 3.5% would mean CAPE~29, S&P CAPE is a little higher, though global a few points lower.
Enjoyed your post but 3.5% is real whereas 1/CAPE is nominal?
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Re: 3.5% Equity Risk Premium

Post by abc132 »

NiceUnparticularMan wrote: Fri Apr 14, 2023 12:38 pm
abc132 wrote: Fri Apr 14, 2023 11:24 amThe lesson is not that returns will be fantastic but that the predictions are not particularly actionable.
I agree that trying to shift around your asset allocation in response to models like this is unlikely to be helpful and could easily be harmful.

However, there are potential implications for things like savings rates and withdrawal rates that could be actionable.
Neither of these are actionable as estimates need to be overly conservative due to variability. A central estimate moving up or down a few percent with an 18% standard deviation is not meaningful. It would be far better to measure portfolio size as a percentage of goals and use this to determine AA. Savings rate based on a few percent real returns - historically conservative but without respect to current predictions.

Unfortunately people do act on these estimates despite their historical inaccuracy.
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Re: 3.5% Equity Risk Premium

Post by LeftCoastIV »

HanSolo wrote: Fri Apr 14, 2023 9:52 am
watchnerd wrote: Fri Mar 31, 2023 4:22 pm I thought this was interesting:
Concluding remarks
This chapter has built on our estimates of the equity risk premium in order to look to the future. We use a building block approach to decompose past returns. After adjusting for non-repeatable factors that favored equities in the past, we infer that investors can expect an equity premium (relative to bills) of around 31⁄2% on a geometric mean basis and, by implication, an arithmetic mean premium of approximately 5%. We have also examined risk premiums for fixed-income investing – both the maturity premium and (in less detail) the credit premium.
From:

Credit Suisse Global Investment Returns Yearbook 2023 Summary Edition
Well then... it's interesting that the above matches my off-the-cuff, back-of-the-napkin guesstimate, one month ago, of what's going on in the minds of institutional investors (from another thread, in the context of why the crash of 2023, widely predicted by many pundits around the new year, hasn't happened):
HanSolo wrote: Sat Mar 11, 2023 1:52 pm My guess: there may be a longer-term estimate (e.g., in the minds of large institutional investors) of S&P fair value in the mid-5000s by end-of-decade, and the pundits think a 5% annualized gain from now until then is unacceptable to stock investors, so they think the market has to drop to levels where the annualized gain will be more like 10% (while still on target to reach the mid-5000s by end-of-decade). But if market participants, by and large, are OK with that 5% annualized return, then the market doesn't need to drop as much as the pundits expect.
The actionable thing (for me, anyway) is to stick to my target AA.
I see the main takeaway being that dogmatic belief in the 25x (or 4% withdrawal) planning assumption that is the subject of so many posts, may not hold true going forward. That said, I don’t think people blindly withdraw 4% each year until they run out if money. They review reality and adjust. But before you stop deploying your human capital (and retire) check your assumptions against forecasts like this.

The early FIRE crowd is more exposed, given the longer timeframe for optimistic planning assumptions to fall short.
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Re: 3.5% Equity Risk Premium

Post by Tamalak »

watchnerd wrote: Fri Apr 14, 2023 9:55 am My napkin math:

10 year equity risk premium of global equities vs 10 YR TIPS:

2.99% real
Does mean that if 10 YR TIPS are returning 3% nominal and inflation is 3%, equities would be expected to return 9%? (TIPS + inflation + premium). Discounting your concern that valuations will go down further due to PEs.
Always passive
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Re: 3.5% Equity Risk Premium

Post by Always passive »

watchnerd wrote: Fri Apr 14, 2023 10:00 am
NiceUnparticularMan wrote: Fri Apr 14, 2023 9:56 am

I agree at least most economists treat that as an uncontroversial concept.

What I find remarkable, and dangerous even, is the number of arguments made here which seem to depend on not understanding how this concept applies to risky stocks and bonds.

So if "everyone" is (most) economists, sure.

If "everyone" is posters here? Not so much.
Fair point.

And given the number of Boglehead forum posters who seem to have been shocked by recent bond fund behavior, I've concluded that Boglehead overall economic / financial literacy is lower than I thought.
Why are you surprised?
A key concept of the Bogleheads philosophy is that “no one knows nothing”
And I think that we can agree with that!
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