Risk Premia Forecasts: Major Asset Classes - Tuesday, Feb. 2

The expected risk premium for the Global Market Index (GMI) continues to hold in the mid-5% range. In today’s revision, the long-run projection ticked down to 5.4% for January, slightly below the previous month’s 5.5% estimate. The forecast is a long-term outlook for this multi-asset-class index’s performance over the “risk-free” rate via a risk-based model (details below).

Although revisions to GMI’s expected risk premia can be volatile in the short run, recent history shows this forecast has been relatively stable. A year ago, for example, the model projected a 5.0% premium, which is modestly below today’s update.

GMI is an unmanaged, market-value-weighted portfolio that holds all the major asset classes (except cash) and represents a theoretical benchmark of the “optimal” portfolio. Using standard finance theory as a guide, this portfolio is considered the best choice for the average investor with an infinite time horizon. As such, GMI is useful as a baseline to begin research on asset allocation and portfolio design. Not surprisingly, GMI’s history suggests the portfolio tends to be competitive with efforts to beat it, especially after adjusting for risk.

For another perspective on the benchmark’s outlook, we can adjust the forecast to reflect recent market conditions. For example, modifying the numbers to incorporate short-term momentum and medium-term mean-reversion market factors (defined below) cuts GMI’s ex ante risk premium to an annualized 4.7%.

All forecasts are wrong in some degree, but GMI projections are expected to be comparatively reliable vs. the estimates for the individual asset classes that are used to generate the benchmark’s forecast. Predictions for the individual market components are subject to greater uncertainty vs. aggregating the forecasts into the GMI outlook — a process that may cancel out some of the errors in the underlying market estimates.

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Disclosure: None.

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