Risk Premia Forecasts: Major Asset Classes - Tuesday, May 4

The expected risk premium for the Global Market Index (GMI) in the long run ticked higher again in April, rising to 5.9% annualized — modestly above the previous month’s estimate. The current expected return estimate — defined as performance above the “risk-free” rate — is still well below the previous realized performance peak for GMI, but today’s revision represents a solid bounce off the lows for recent projections.  

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. Accordingly, GMI is useful as a baseline to begin research on asset allocation and portfolio design. GMI’s history suggests that this benchmark portfolio is competitive with the most active strategies, especially after adjusting for risk and trading costs.

Using recent market activity to adjust the benchmark’s outlook reduces the forward estimate substantially. For example, modifying the numbers to incorporate short-term momentum and medium-term mean-reversion market factors (defined below) reduces GMI’s ex-ante risk premium to an annualized 4.8%.

All forward estimates are wrong in some degree, but GMI projections are expected to be relatively reliable vs. the forecasts 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 for projecting GMI’s risk premia — a process that may cancel out some of the errors in the underlying market estimates.

For 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 risk-premium performance (red line) in recent history has been relatively steady and is currently 7.0% annualized, well below the previous peak of 8%-plus. The current risk premium forecast for GMI — 5.9% — suggests that investors should manage expectations down for multi-asset-class strategies relative to results in recent years.

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Disclosures: None.

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