Abstract
The expected equity risk premium is arguably the most important number in modern finance with its implications stretching far and wide. However, over recent years the way this number has been derived has generally been a thoughtless process. As a result, there is a perceived consensus that the risk premium should be roughly 5%. Such a consensus has been shaped by naiveté in the investment community as historical returns have fallen within this proximity, with impressive consistency.
Such a premium has been based on decades of historical returns that are no longer suited to today’s markets. These historical returns have been biased upwards as a result of previous events that cannot be expected to repeat going forward. Expecting a premium of 5% is seen as excessive, especially when viewed from a long-term horizon, to the extent that any serious financial institution would not bother holding bonds, as the probability of equities drastically outperforming would simply be too high.
In the study we determine an unbiased estimate of the forward-looking South African equity risk premium. The determined premium is not just an isolated snapshot of today’s premium, but an objective expectation throughout the South African market history. To derive such an estimate, two fundamental components are determined. The first being an objective estimate of an expected real return from equities, with the second being a reasonable estimate of an expected real return from a relative risk-free asset.
Based on the earlier work of Arnott and Bernstein (2002), the study demonstrates a forward-looking equity risk premium that is nowhere near the levels experienced in the past. Currently, an objective evaluation of previous returns and growth rates pegs the expected risk premium at 1.89%. Such a premium is certainly sobering and reveals a stark reality for anyone who is consistently expecting a 5% risk premium. We suggest that these investment professionals temper their expectations by more than halving their expected risk premium.
M.Com. (Financial Management)