(February 6, 2013) — What do most investors estimate the equity risk premium to be? Chances are they are overly optimistic, say a trio of eminent academics.
Over the past 113 years the premium investors could have reaped from investing in global stock markets was 4.1%, according to the annually updated Global Investment Returns Yearbook 2013, published yesterday.
The yearbook is compiled each year by professors Elroy Dimson, Paul Marsh, and Mike Staunton at the London Business School in association with Credit Suisse, and tracks investments made in 22 major international equity and bond markets.
Since 1900, the equity risk premium has been 4.1%, the trio said, but going forward, this was likely to be lower. From now on, the excess return over bonds will be between 3% – 3.5%, the professors said.
“What do investors expect?” asked Marsh at the yearbook’s launch in London. “Pre-1950, investors’ ideas were well calibrated. Between 1950 and 1999, they were lucky. Ten years ago investors thought the equity risk premium was 6%, a recent poll of academics now believe it to be nearer 3% – 3.5%.”
The professors calculated the actual figure by looking at historical data and making adjustments for future returns.
From the 4.1% historical average, they subtracted 0.4%, which they attributed to the expansion of the price-to-dividend multiple, and a further 0.5% for the growth in dividend payments. These factors were unsustainable in future economic markets, they said.
Marsh said fund managers’ claims of real returns of between 7% and 10% were “unrealistic”. He added that pension funds with projected equity return real returns of up to 10% were “patently ridiculous, but still 71% of them in a recent poll said they believed they could achieve it.
“Defined benefit and unfunded pension funds have some tough choices to take,” said Marsh. “It is something they have to tackle. They have to take on board that return rates are lower.”
He said that compulsory 4% spending rules for some charities made investment tricky if the equity risk premium is lower than most people think.
“Fund management fees of 1% to 1.5% are gobbling up half of the return,” Marsh said “when returns are this low. It is not sustainable.”
For a look at the leading academics in finance – and what their work has meant for investors, see the January/February edition of aiCIO, published at the end of this month.