Why do investors buy stocks when they are riskier than Treasury bonds? They invest in stocks because they expect a higher return, a premium, from stocks over bonds. The market risk premium is the expected return that today’s investors feel justifies taking on so-called risk assets. The market risk premium fluctuates based on market sentiment, with higher premiums reflecting cheaper stocks and lower premiums reflecting steeper prices. Investors can use multiple methods to estimate the market risk premium based on readily available data.
The market risk premium can be estimated by adding the dividend yield of the stock market to its earnings growth rate, less the risk-free rate. Broad stock-market indices like the Russell 3000 or the S&P 500 can be used to approximate the entire market for public stocks, and dividend yields and forecasted growth rates for these indices are available at online-finance portals. The yield of Treasury bonds with a maturity that roughly matches an investor’s expected holding period should be used as the risk-free rate. They also are available at online finance portals.
Geometric-average market risk premiums can be calculated from the excess of past stock-market returns over Treasury-bond returns. NYU’s Professor Aswath Damodaran cautioned that historical averages can vary depending on the region and time period. The 2012 edition of his article “Equity Risk Premiums (ERP): Determinants, Estimation and Implications” noted that historical market risk premiums were 6 percent as viewed from 1999 and 4 percent as viewed from 2011. The historical average fell after lower premiums from the first decade of the new millennium were included. Extrapolation from past values should be used with caution.
Historical-average dividend yield and historical-average earnings growth can be added to estimate the market risk premium. An April 2002 article in the Journal of Finance written by Professor Eugene F. Fama and Professor Kenneth R. French used data from 1872 to 2000 to calculate an average market return of 3.54 percent per year after accounting for inflation.
Neither forecasts of earnings growth nor historical market risk premiums guarantee future returns. The factors that will shape stock-market performance in the future are not those that are imagined today and they are not the same as those that shaped past returns. After all, the market risk premium is only the expectation of future returns based on unknowable outcomes.
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