Read more on estimating risk premiums
risk premiums and implied
risk premiums for the US
Implied equity risk premium
| The obvious problem is that historical
prremiums are backward looking when what you really want is the
premium for the future. There are also three measurement problems:
There is an alternative to historical
premiums. Based upon how stocks are priced collectively (looking
at a broad equity index) and the expected cashflows you would
get from buying these stocks (dividends, for instance), you can
back out the risk premium that investors are demanding. This
risk premium is called an implied equity risk premium.The historical risk premium form
1928-2002 in the United States was 4.53%. The implied equity
risk premium declined to 2% at the height of the bull market
in 1999 and has averaged about 4% over the last 40 years.
Historical risk premiums come with
large standard errors. Even with 75 years of data on stock and
bond returns, which we can get for the United States, the standard
errors remain high (about 2.5%). The problem becomes worse in emerging
markets with less data. If you go further back in time (to 1871,
for example), you run the risk of getting a risk premium that means
very little at the current time.
If you decide to use historical data
in the United States because you have a long and easily accessible
history, you run into a problem of selection bias. After all, the
U.S, market was the most successful market of the twentieth century;
as a consequence, the premium you get will be too high as a forward-looking
estimate. A more reasonable estimate would require you to look
across a number of different equity markets over the twentieth
century and compute an average premium over the markets.
Markets are priced based upon investor
assessments of how risky stocks are and how much of a premium they
should charge for investing in stocks. In bullish times, stock
prices rise as investors become more optimistic about the future
and reduce their required risk premiums. As stock prices rise and
deliver high positive returns, historical risk premiums go up.
In other words, historical risk premiums rise just as investor's
expected risk premiums decrease.