Tuesday, March 9, 2010

Equity Risk Premiums and the Fear of Catastrophe

As many of you already know, I am a little fixated on the equity risk premium. More than any variable, it explains what happens in equity markets both in the short term and the long term. In fact, I have at least a dozen posts over the last year and a half on the evolution of the equity risk premium in the US and globally.

The equity risk premium measures what investors collectively demand as a premium over and above the riskfree rate to invest in equities as a class. In practice, many analysts use historical data to estimate this premium. Thus, if investors have earned 9% on stocks over the last 80 years and 4% on treasury bonds over that same period, the historical premium is 5% and it is also used as the equity risk premium in valuation. My problem with this approach is that it is not only backward looking (you want a premium for the next decade, not the last 8 decades) but yields extremely noisy estimates. On my website, for instance, I estimate the historical risk premium for stocks over treasury bonds from 1928 - 2009 to be 4.29% but I also estimate the standard error in this number to 2.40%.

It is to remedy these problems that I compute an implied equity risk premium, where I back out the premium from the current level of stock prices and expected cash flows; it is analogous to estimating the yield to maturity on a bond. While this approach requires its share of inputs - expected growth rates and cash flows on stocks - the estimate of the premium is not only forward looking but comes with a far tighter range on the value. Furthermore, it is dynamic and reflects what is happening in the world around you.

On September 12, 2008, a couple of weeks before I made my first posting to this blog, the implied equity risk premium in the US was 4.36%. In the next 13 weeks, that implied premium rose to 6.43%, varying more than it had in the previous 25 years put together. It taught me an important lesson: even in developed markets, equity risk premiums can change quickly and need to be updated frequently. Since the crisis, I have been updating premiums every month and the implied equity risk premium at the start of March 2010 was 4.44%, back to where it was before the crisis.

How do we explain this rapid back tracking to pre-crisis premiums? While some view it as irrational, there is a rational explanation. One component in the equity risk premium is the fear of catastrophe. What is a catastrophe? It is that infrequent event, which if it occurs, essentially puts you under water as an investor for the rest of your investing life. The Great Depression was a catastrophe for the US: an investor in US stocks in 1928 would not have recovered his principal for almost 20 years. The Japanese market collapse in the late 1980s was a catastrophe. Investors who had their investments in the Nikkei in 1989 will not make their money back in their lifetimes. In good times, that fear recedes and investors are lulled into complacency; stocks go down, but it assumed that the long term trend is always up. In fact, we hear nonsensical stories about how stocks always win in the long term; if these stories were true, the equity risk premium should be zero for really long term investors. In crisis times, the fear of catastrophe rises to the top of all concerns and drowns out all other information. In December 2008, there was the real possibility of a complete financial meltdown and the equity risk premium reflected that. In January 2010, that fear had dropped off enough that people were reverting back to the pre-crisis premiums. It is entirely possible that we over estimated the likelihood of catastrophe in December 2008 and are under estimating it now, but I think that it is the only explanation that I can provide.

I have pointed you to a paper on equity risk premiums that I have. I just completed my 2010 update to the paper. Most of the changes are in the data and the text of the paper itself is relatively unchanged. If you are interested, try this link:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1556382

You can rest assured that I will nag you on this topic for as long as I maintain this blog.

9 comments:

Roberto Ushisima said...

Dear Damodaran,

What do you think about Pablo Fernández's opinions about equity risk premium? Opinions exposed in this paper, for example. http://ssrn.com/abstract=1473225

Aswath Damodaran said...

I don't pass judgment on other people's opinions. I think you can read what he has written and make your own judgments.

Lionel said...

Professor Damodaran,
I agree completely with your assessment that the equity risk premium is one of the most important numbers in valuation. I read over a few parts of your 99-page equity risk premium essay (2010) and I was particularly struck by your data findings that implied risk premiums seem to have beaten the other premiums (historical, survey, average, etc) in terms of predictive power.

You probably know what's coming next. We all have different investment philosophies regarding the markets, and one of your primary points is that investors who believe that markets will be efficient in the aggregate/long-run, should use the implied equity risk premium. Given the relative failures of the other risk premiums, why not proclaim the triumph of the market efficiency investment philosophy?

Of course the technicians and the unbelievers will cry in protest, but isn't market efficiency the goal anyway? (of not just stock markets but markets in general).

This isn't really a suggestion, more of a speculation. If all market participants believed in market efficiency, wouldn't the stock markets naturally become more efficient, making prices less volatile, like they have become in real markets?

Lionel said...

Sorry for the double-post. Just want to clarify, I don't mean the complete market efficiency espoused by people like Burton Malkiel. But long-term, aggregate market efficiency.

Neha said...

hello...how can I follow ur blog? Can't see the link?

Laude Guiry said...

Hi Professor Damodaran

I've built an ERP model for South Africa based on historical earnings of equity markets vs govt gilts.

I've opted for a 3 year geometric moving average return.

I've read yours and many other models but none indicates what interval one should you for the geometric mean. The results I get vary significantly depending on the period I use to derive the geometric mean.

One would intuitively guess that since this is a long term calculation, a 10 year moving average geometric return would be more reflective of long-term risk than my current 3 year moving average.

However, my take is that by using a 10 year moving average, a add more bias to the calculations.

Please advise
Joao (Mocambique)

Tony said...

Equity release schemes have proved very popular in recent years. As living costs rise, equity release schemes, which typically let you borrow money against the value of your home with the debt being repaid from its sale only after your death, seem an attractive solution to many cash-poor, asset-rich retirees.

Diego Torres Borda said...

Dear Damodaran,
Have you heard about Prospect Theory by Kahneman and Tversky?
You should find interesting how some deviation of expected utility theory (which is in the background of Corporate Finance) support your catastrophe argument.

Tony said...

Equity release schemes have proved very popular in recent years. As living costs rise, equity release schemes, which typically let you borrow money against the value of your home with the debt being repaid from its sale only after your death, seem an attractive solution to many cash-poor, asset-rich retirees.