Risk Premia Forecasts: Major Asset Classes - Wednesday, Dec. 2

The expected risk premium estimate rose for The Global Market Index (GMI), increasing to an annualized 5.3% in today’s revision. That’s a relatively sizable jump relative to last month’s forecast. The estimate represents a long-run projection for the index’s performance over the “risk-free” rate via a risk-based model (details below).

In the short run, revisions to this forward-looking projection can be volatile. Year to date, for example, the monthly updates have posted estimates ranging from 3% to the current 5.3%.

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.

There are several possibilities for 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) trims GMI’s ex ante risk premium to an annualized 4.5%.

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

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 performance (red line) in recent history has been in the upper range of results since 2008. At the end of last month, GMI earned an annualized 7.1% risk premium.

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Disclosure: None.

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