Risk Premia Forecasts: Major Asset Classes, Thursday, January 3

The expected risk premium for the Global Market Index (GMI) fell to an annualized 4.2% in December, moderately below the 4.6% estimate in the previous month. The revised projection for GMI (an unmanaged market-value-weighted portfolio that holds all the major asset classes) represents the ex ante premium over the projected “risk-free” rate for the long run.

Adjusting for short-term momentum and medium-term mean-reversion factors (defined below) generates a fractionally higher ex ante risk premium for GMI: an annualized 4.3% forecast.

The projections remain well below GMI’s historical performance for the trailing 10-year period through last month. The benchmark earned a solid 6.7% annualized risk premium for the decade through December 2018, substantially above GMI’s current unadjusted 4.2% long-run forecast.

All forecasts are likely to be wrong to some degree, but the projections for GMI are expected to be somewhat more reliable vs. the estimates for the individual asset classes. Predictions for the market components are subject to greater uncertainty compared with aggregating forecasts, a process that may cancel out some of the errors through time.

For a bit of historical perspective, consider the chart below, which shows the rolling 10-year annualized risk premia for GMI, US stocks (Russell 3000), and US Bonds (Bloomberg Aggregate Bond) through last month. Note that GMI’s current 10-year performance (red line) has pulled back recently, but remains elevated compared with results over the past decade.

Now let’s turn to a summary of the methodology and rationale for the estimates above. The basic idea is to reverse engineer expected return, based on risk assumptions. Rather than trying to predict return directly, this approach relies on the moderately more reliable model of using risk metrics to estimate the performances of asset classes. The process is relatively robust in the sense that forecasting risk is slightly easier than projecting return. With the necessary data in hand, we can calculate the implied risk premia with the following inputs:

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Disclosure: None.

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