Risk Premia Forecasts: Major Asset Classes - Tuesday, Jan 5, 2021

The expected risk premium for the Global Market Index (GMI) for the long run continued to tick higher in December. Today’s revised estimate rose to an annualized 5.5%, based on current data. That’s up from last month’s 5.3% projection. These forecasts represent long-run outlooks for the index’s performance over the “risk-free” rate via a risk-based model (details below).

Over short-to-medium-term periods, revisions to these forward-looking numbers can be volatile. For example, a year ago GMI’s ex ante risk premium was 5.0% — 50 basis points lower vs. today’s estimate.

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, based on the so-called market portfolio. 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.

For additional perspective on the outlook, it’s reasonable to consider how the projections stack up after adjusting the raw forecast to reflect recent market and economic conditions. For example, adjusting for short-term momentum and medium-term mean-reversion market factors (defined below) significantly trims GMI’s ex ante risk premium to an annualized 4.5%.

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

For some historical context, here’s a chart of 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 realized 10-year performance (red line) in recent history has been in the upper range of results in recent years. At the end of last month, GMI earned an annualized 7.1% risk premium.

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Disclosure: None.

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