Oxstones Investment Club™From Portfoliosolutions.com site,
All financial assets are priced based on their perceived risk. The greater the perceived risk, the greater the expected return. When the perceived risk of an asset class is low, the expected return is also low relative to more risky asset classes.
Each year,we analyze the primary drivers of asset class long-term returns including risk as measured by implied volatility, expected earnings growth based on GDP estimates and foreign business expansion, market implied inflation based on the spread between long-term Treasury Bonds and TIPS, and current cash payouts from interest and dividends on bond and stock indexes. These factors plus others are used in a valuation model to create an estimate for risk premiums over the next 30 years. In a sense, we believe these expected returns reflect what the market is estimating will be a fair payment for each asset class over T-bills over the long-term.
Risk Based Methodology
There is a basic premise that is universal among investors. Riskier asset classes are expected to deliver higher long-term rates of return. If you can estimate the risk in an investment, you can also estimate the return required of that investment relative to all other investments.
A three-month Treasury bill has basically no risk except perhaps, the risk that inflation will be higher than the yield. A twenty-year Treasury bond has interest rate risk, meaning interest rates may rise after you buy the bond. Since there is greater risk in T-bonds over T-bills, we know that the expected return of T-bonds has to be higher than the T-bill over twenty years because the T-bond has interest rate risk. The difference in expected return on the twenty-year bond over the T-bill yield is called “term risk premium”.
Instead of buying a twenty-year T-bond, an investor may decide to invest in a twenty-year “A” rated corporate bond. Unlike the T-bond, corporate bonds are not guaranteed by the U.S. government. As such, a “credit risk premium” is expected to be earned on the corporate bond in addition to a term risk premium.
Common stock of a company has more risk than its corporate bond because returns are based on earnings rather than interest, and in the case of bankruptcy, the stock holders get wiped out while the bond holders end up owning the company. Therefore, stockholders have greater risk than bond holders and are expected to earn a higher return. The extra return of stocks over bonds is known in academia as an “equity risk premium”.
Results and Limitations
The table below is our expected return for all major equity and fixed income asset classes over the next thirty-years. The table is provided to be a guide when constructing a long-term diversified portfolio. These estimates are not expected to be completely accurate. Actual returns will likely differ in several asset classes.
Of all the returns we estimate, perhaps inflation is the most difficult to forecast. There are so many variables that affect inflation that it’s nearly impossible to guess the future. This is why we prefer to show expected market returns on a pre-inflation basis. We have more faith in our inflation-adjusted (real return) forecasts than our post inflation forecasts.
Thirty-Year Estimates of Bonds, Stocks and REITs Assuming a 2.8% Inflation Rate
| Asset Classes | Real Return | With 2.8% Inflation | Risk* |
| Government-Backed Fixed Income | |||
| U.S. Treasury bills (1-year maturity) | 0.3 | 3.1 | 2 |
| 10-year U.S. Treasury notes | 1.3 | 4.1 | 6 |
| 20-year U.S. Treasury bonds | 1.5 | 4.3 | 7 |
| 20-year inflation protected Treasury (TIPS) | 1.8 | 4.6 | 8 |
| GNMA mortgages | 1.8 | 4.6 | 8 |
| 10-year tax-free municipal (A rated) | 1.5 | 4.3 | 7 |
| Corporate and Emerging Market Fixed Income | |||
| 10-year investment-grade corporate (AAA-BBB) | 2.4 | 5.2 | 9 |
| 20-year investment-grade corporate (AAA-BBB) | 2.5 | 5.3 | 10 |
| 10-year high-yield corporate (BB-B) | 4.0 | 6.8 | 15 |
| Foreign government bonds (unhedged) | 2.0 | 4.8 | 8 |
| U.S. Common Equity and REITs | |||
| U.S. large-cap stocks | 5.0 | 7.8 | 19 |
| U.S. small-cap stocks | 6.0 | 8.8 | 22 |
| U.S. micro-cap stocks | 7.0 | 9.8 | 25 |
| U.S. small-value stocks | 8.0 | 10.8 | 27 |
| REITs (real estate investment trusts) | 5.0 | 7.8 | 19 |
| International Equity (unhedged) | |||
| Developed countries | 5.0 | 7.8 | 19 |
| Developed countries small company | 6.0 | 8.8 | 22 |
| Developed countries small value companies | 8.0 | 10.8 | 27 |
| All emerging markets including frontier countries | 9.0 | 11.8 | 29 |
*The estimate of risk is the estimated standard deviation of annual returns.
Laddering Risk Premiums
Another way to look at asset class expected returns is by layering risk premiums. As you go down the list in the table below, each asset class has the premium of the asset class or category above it, plus a new risk premium. Adding risk premium layers derives an asset class expected return.
| T-Bills | 10-year Treas. Notes | 10-year Corp. Bonds | Large-Cap Stocks | Small- Cap Value Stocks | |
| Real risk-free rate | 0.3% | 0.3% | 0.3% | 0.3% | 0.3% |
| Term risk premium(intermediate) | 1.0% | 1.0% | 1.0% | 1.0% | |
| Credit risk premium (intermediate) | 1.0% | 1.0% | 1.0% | ||
| Equity risk premium | 2.7% | 2.7% | |||
| Value stock risk premium | 2.0% | ||||
| Small stock risk premium | 1.0% | ||||
| Real Expected Return | 0.3% | 1.3% | 2.3% | 5.0% | 8.0% |
| Inflation | 2.8% | 2.8% | 2.8% | 2.8% | 2.8% |
| Total Expected Return | 3.1% | 4.1% | 5.1% | 7.8% | 10.8% |
No one knows exactly what the returns of the markets will be over the next thirty years. However, the risk in an asset class is fairly stable over time, and that tends to drive the long-term risk premium.
The acceptance of a market forecast is an important step to creating a proper asset allocation. The forecast should always try to err on the conservative side. It is wise to expect and plan for lower returns and then be pleasantly surprised if the forecast is too low than to rely on a rosy forecast and possibly run out of money later in life. As the saying goes, it is better to be safe than sorry.
Tags: bond risk premiums, credit risk premiums, equity risk premiums, risk premiums