Risk Premium for Stocks

This Fortune article, “Investors Are in for a Shock,” talks about some recent comments issued by Alan Greenspan: “Investors, the Fed chairman intoned, normally demand a substantial ‘risk premium’—a high return in exchange for taking a chance that they may lose money. Now, though, investors ‘accept increasingly low compensation for risk.’” The author goes on to explain:

Greenspan’s argument rests on the idea of the risk premium—the extra return (over a supersafe investment like Treasury bills) that investors have traditionally received for putting their money in peril. For stocks, the risk premium equals the expected real (inflation adjusted) return on a broad portfolio of shares, minus the real interest rate. To calculate the risk premium that stock investors are getting today, we turned to Asness. For expected return, Asness uses the earnings yield on the S&P 500—earnings per share divided by price—adjusted for cyclical swings in profits. Asness pegs today’s earnings yield at 4.3%.

To derive the real interest rate, Asness takes today’s ten-year Treasury yield of 4.6% and subtracts the average inflation rate over the past five years, 2.7%, to get a real rate of 1.9%. So today’s risk premium is the 4.3% expected return minus the 1.9% real interest rate, or 2.4%. That’s about half the 5% margin that stocks have delivered for the past 80 years. So investors aren’t getting the usual extra bang for holding equities.

This will lead to two possible outcomes. At best,

people who buy at today’s levels are in for a sustained period of subpar returns, perhaps 4% or 5% annually, after inflation. That’s because the best predictor of future gains is the price you pay. “High prices and low risk premiums today mean low returns tomorrow,” says Cliff Asness, an economist who runs AQR Capital, a $17 billion hedge fund.

and at worst, “the more dire alternative is a steep fall in prices that makes everything from the S&P 500 to homes what they aren’t today—that is, great investments.”

Popularity: 3% [?]

0 Responses to “Risk Premium for Stocks”


  • No Comments

Leave a Reply