Risk Premia Forecasts: Major Asset Classes - Wednesday, June 2

The Global Market Index’s (GMI) expected risk premium held steady at 5.9% annualized in May, matching the previous month’s estimate. The forecast — performance above the “risk-free” rate – remains well below the realized risk premium in recent history, based on rolling 10-year annualized results.

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 an optimal portfolio 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’s performance is competitive with active asset-allocation strategies overall, especially after adjusting for risk and trading costs.

Using short-term momentum and medium-term mean-reversion market factors (defined below) to adjust the forecast reduces GMI’s ex ante risk premium to an annualized 4.9%.

All forward estimates are wrong in some degree, but GMI long-run 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 7.2% annualized. That’s well below the previous peak of 8%-plus. The current risk premium forecast for GMI — 5.9% — suggests that multi-asset-class strategies will generate lesser returns relative to results posted in recent years.

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Disclosures: None.

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