Monday, May 5, 2008

What Risk Premium Is “Normal”?

I said earlier today, in "Will Green Investors Demand Higher Risk Premia?" that the short answer was yes and that I would expand (expound) on this idea. First though, it might be useful to link to a couple old pros, Robert Arnott and Peter Bernstein. If you know this stuff, this is a good brush-up, if you don't, this is a very readable 22 page PDF.

The goal of this article is an estimate of the objective forward-looking U.S. equity risk premium relative to bonds through history—specifically, since 1802. For correct evaluation, such a complex topic requires several careful steps: 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. We demonstrate that the long-term forward-looking risk premium is nowhere near the level of the past; today, it may well be near zero, perhaps even negative....