EQUITY RISK PREMIUM: EXPECTATIONS GREAT AND SMALL

North American Actuarial Journal,  Jan 2004  by Derrig, Richard A,  Orr, Elisha D

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All six methods reproduce the historical long-horizon geometric mean of 10.70% as shown in Appendix D. Since the source of most other researchers' lower KKP is the dividend yield, Ibbotson and Ghen (2003) recast the historical results in terms of ex ante forecasts for the next 75 years. Their estimate of 9.37% using supply side methods 3 and 4 is approximately 130 basis points lower than the historical result. Within their methods, they also show how the substantially lower expectation of 5.44% for the long mean geometric return is calculated by omitting one or more relevant variables. Underlying these ex ante methods are the assumptions of stationarity of the mean ERP return and market efficiency, the absence of the assumption that the market has mispriccd equities. all of their methods are aimed at producing an unconditioned estimate of the ex ante ERP.

As opposed to short-run, conditional estimates from Campbell and Shiller and others, Gonstantinides (2002) sought to estimate the unconditional ERP, more in line with the goal of Fama and French (2002) and Ibbotson and Ghen (2003). He began with the premise that the unconditional ERP can be estimated from the historical average using the assumption that the ERP follows a stationary path. he suggested that most of the other research produces conditional estimates, conditioned upon beliefs about the future paths of fundamentals such as dividend growth, price-earnings ratio, and the like. While interesting in themselves, they add little to the estimation of the unconditional mean ERP.

Gonstantinides (2002) used the historical return and adjusted downward by the growth in the priceearnings ratio to calculate the unconditional ERP. he removed the growth in the price-earnings ratio because he was assuming no change in valuations in the unconditional state. he gave estimates using three periods. For 1872-2000, he used the historical ERP, which is 6.9%, and, after amortizing the growth in the price-dividend ratio or price-earnings ratio over a period as long as 129 years, the effect of the potential reduction was no change. Therefore, he found an unconditional arithmetic, short-hori%on ERP of 6.9% using the 1872-2000 underlying data. For 1951-2000, he again started with the historical ERP, which is 8.7%, and lowered this estimate by the growth in the price-earnings ratio of 2.7% to And an unconditional arithmetic, short-horizon ERP of 6.0%. For 1926-2000, he used the historical ERP, which is 9.3%, and reduced this estimate by the growth in the price-earnings ratio of 1.3% to nnd an unconditional arithmetic, short-horizon ERP of 8.0%. He appealed to behavioral finance to offer explanations for such high unconditional ERP estimates.

From the perspective of giving practical investor advice, Malkiel (1999) discussed "the age of the millennium" to give some indication of what investors might expect for the future. He specifically estimated a reasonable expectation for the first few decades of the 2 F' century. he estimated the future bond returns by giving estimates if bonds are held to maturity with corporate bonds of 6.5-7%, long-term zero-coupon Treasury bonds of about 5.25%, and TIPS with a 3.75% return.