Category Archives: Equity Risk Premium

Credit Suisse annual update on market performance

Credit Suisse has for several years now put out an annual Credit Suisse Global Investment Returns Yearbook 2013 is out now.

It’s worth reading in its entirety for the insights. I don’t agree with everything there, and I certainly don’t agree with the widely held view (not among the authors) that the universe of countries included in the survey is supposed to be somehow representative of the world.

The countries chosen have an absolutely clear bias in their selection. They are successful economies with successful financial markets. They are included by virtue of their long-term success and capital growth and returns for investors.

The authors know this, but many readers don’t.  The returns per this survey are an overly rosy view of possible future returns.

Surveys, papers and books on the ERP

Some interesting papers on the ERP:

Market Risk Premium used in 56 countries in 2011: a survey with 6,014 answers

The Equity Premium in 150 Textbooks

Equity Premium: Historical, Expected, Required and Implied

  • This work provides a fairly in-depth analysis of the differences between the various definitions of ERP and a comprehensive survey of major sources for estimates of these. In general, the estimates of the Expected ERP over T-bonds (rather than short-dated T-bills) are in line with the range I use of 3% to 5% with several showing values to the lower end of this range.
The debate certainly isn’t over, but these papers and the referenced papers, research and textbooks are a good starting place to get up to speed.





Your ERP estimate is still too high

I recently had a conversation with a colleague who had been told that “Credit Suisse recommended an Equity Risk Premium of 7%”.  I’m curious to know whether they truly view that as an appropriate ERP.  If your ERP is 7%, it’s still too high.

The authors of Triumph of the Optimists have joined forces with Credit Suisse to publish the Credit Suisse Global Investment Returns Yearbook 2010 (pdf) which is a brief update of their brilliant research.  You should definitely read the original book.

The updated research shows a very familiar picture to that of the book.  Here are a few important outcomes:

  • Realised excess returns of equities over bonds have been negative for most countries for the last decade.

Clearly, using realised excess returns (or historical ERPs) over a short period as a measure of future ERP is a bad idea.  I’m fairly sure the future ERP is positive.

  • For the World, the US, the UK, Australia, Belgium, Canada, Denmark, France, Germany, Ireland and South Africa (a few countries I chose to look at before I realised the trend is near-universal) have had declining historical ERPs over the last 110 years. Some have had a few bumps in between, but the overwhelming trend has been downward.  The last decade’s poor performance has obviously helped establish this trend, but it was pretty well established for most of these countries even without the last decade.

Using unadjusted historical ERPs over long periods is a dangerous idea because trends in the data make it a poor estimate of future experience.

Pension funds don’t have enough junk

Junk Bonds are debt instruments issued by corporates that have relatively low credit ratings.  They pay interest at high rates as a result.

Typically viewed as risky investments, the junk bonds boom of the 80s showed that there is more to junk than just a risky investment.

Locally, our pension funds and other retirement savings money should be more heavily invested in junk bonds. I’m surprised more people aren’t talking about this. It might be due to the limited availability of junk in the SA market. On the other hand, if demand picked up, I’m sure we could see more original-issue junk bonds as yields drop and become more attractive financing vehicles.

There are always marks for considering tax

Why should pension funds be invested in junk? Tax. Approved retirement savings vehicles in South Africa don’t pay income tax. Thus, the value of securities that would attract significant tax is higher for these investors than for the market as a whole. If risk and return are balanced for the market as a whole, the extra return available to retirement vehicles through not paying tax is a bonus over and above that appropriate for the risk.

Conversely, pension funds should stay far away from tax-efficient instruments such as preference shares. The prices of these instruments have already been bid up by tax-paying investors. Continue reading Pension funds don’t have enough junk

How not to lose money in Make a Million

I have a clear strategy for how not to lose money playing the Make a Million competition. As I explain it, you may come up with some smart tactics to win the competition and enhance your returns, but you’re on you’re own there.

So, how does one not lose money with the Make a Million competition?

Don’t enter.

You are overwhelmingly like to lose money if you enter this competition. I’ve said this before, and I’ve been right before. I’m right again.

There’s also the little idea that the  structure of the Make a Million competition increases risks of  financial meltdown

Let’s look at some hard statistics to show what I mean.

Telling statistics (what they don’t show)

In the MaM presentation, the organisers include some interesting statistics about number of trades, trading activity and many other metrics.

They don’t show average returns or performance.

So let’s look at some of the numbers:

Raw return data (excluding prize money) based on 2009 MaM competition.

Average Return -11.49%
Expected Loss R 1,149
Median Return -15.06%
Mode Return -9.12%
Probability of breaking even 25.00%
Probability of earning less than 10% 83.00%
Probability of doubling money 1.78%
Probability of winning 0.20%

Suddenly the competition doesn’t look so great, does it?  (This isn’t the first time, here is my analysis of the Comedy and Tragedy that was the 2008 Make a Million competition.) Continue reading How not to lose money in Make a Million

Implied Pension Return Assumptions and the Equity Risk Premium

When companies value pension obligations and required contribution rates, they make assumptions about the expected future investment returns. (Accounting standards require market-based rates reflecting fixed interest returns, but that’s a separate point).

So what assumptions are pension funds making? The WSJ has an interesting article showing that the average US pension fund is assuming future returns of approximately 8%. To put that in perspective, yields on 30 year T-bonds in the US are about 3.9%, 10-year yields are below 3% and inflation is currently about nothing. This is a huge real return and suggests that many of these pension funds may be underfunded.

It’s also interesting to work out what Equity Risk Premiums these valuation assumptions imply. FinanceClippings makes  some educated guesses at likely portfolio construction, and estimates assumed ERPs of nearly 8%. For reasons I’ve described before, an 8% ERP is madness.

My own calculations

FinanceClippings assumes a simple portfolio mix of 50% equities and 50% government bonds in this calculation, and assumes the average yield will be consistent with 30-year assumptions. I would differ slightly here. If we are looking at an overall portfolio, I would expect some investment grade corporate bonds and property in the mix too. These assets could be expected to earn 1% to 2% over risk-free over time (after adjusting for expected default loss on the corporate bonds). These return assumptions may seem low to some, but this is another area where it’s easy to overestimate the possible returns based on inappropriate periods of data. Continue reading Implied Pension Return Assumptions and the Equity Risk Premium

The Power of Misconceptions

In broad terms, we are all mostly ignorant. Worse than ignorant, we have notions and views, firmly held, that are entirely incorrect.

We only complain about what we don’t like

Nobody complains to their boss that they are overpaid. Nobody complains that their pension or social security increases were above inflation last year.

We don’t understand the size of countries and continents

Africa is huge. More of an issue for Europeans and Americans, but the problematic views of the size of Africa due to mapping “projections” used to represent an almost-sphere onto a flat map are almost universally held.

A map showing the real size of Africa as measured in square meters of surface area compared to other countries
The Real Size of Africa

We don’t understand our economy (or at least US students surveyed don’t understand their economy)

Bill Goffe surveyed his students [pdf] with worrying results:

  1. Students assumed 35% of workers earn minimum wage compared to the 2007 actual statistic of 2.7%
  2. Students thought recent US inflation was around 11%, when the real answer is basically 0. (and google is apparently planning some sort of price index of their own)

Plenty more where those came from.

Then a few previous posts of mine highlighting these problems

Estimating the ERP is hard, but the range of common flaws is astounding.

We like to complain about electricity prices, when we haven’t figured out that we pay for it all anyway.