-¡== 2.83% V50

Note that to get reasonable standard errors, we need very long time periods of historical returns. Conversely, the standard errors from ten-year and twenty-year estimates are likely to be almost as large or larger than the actual risk premium estimated. This cost of using shorter time periods seems, in our view, to overwhelm any advantages associated with getting a more updated premium.

• Choice of Riskfree Security: The Ibbotson database reports returns on both treasury bills and treasury bonds and the risk premium for stocks can be estimated relative to each. Given that the yield curve in the United States has been upward sloping for most of the last seven decades, the risk premium is larger when estimated relative to shorter term government securities (such as treasury bills). The riskfree rate chosen in computing the premium has to be consistent with the riskfree rate used to compute expected returns. For the most part, in corporate finance and valuation, the riskfree rate will be a long term default-free (government) bond rate and not a treasury bill

7 For the historical data on stock returns, bond returns and bill returns, check under "updated data" in

8 These estimates of the standard error are probably understated because they are based upon the assumption that annual returns are uncorrelated over time. There is substantial empirical evidence that returns are correlated over time, which would make this standard error estimate much larger.

rate. Thus, the risk premium used should be the premium earned by stocks over treasury bonds.

• Arithmetic and Geometric Averages: The final sticking point when it comes to estimating historical premiums relates to how the average returns on stocks, treasury bonds and bills are computed. The arithmetic average return measures the simple mean of the series of annual returns, whereas the geometric average looks at the compounded return9. Conventional wisdom argues for the use of the arithmetic average. In fact, if annual returns are uncorrelated over time and our objectives were to estimate the risk premium for the next year, the arithmetic average is the best unbiased estimate of the premium. In reality, however, there are strong arguments that can be made for the use of geometric averages. First, empirical studies seem to indicate that returns on stocks are negatively correlated10 over time. Consequently, the arithmetic average return is likely to over state the premium. Second, while asset pricing models may be single period models, the use of these models to get expected returns over long periods (such as five or ten years) suggests that the single period may be much longer than a year. In this context, the argument for geometric average premiums becomes even stronger. In summary, the risk premium estimates vary across users because of differences in time periods used, the choice of treasury bills or bonds as the riskfree rate and the use of arithmetic as opposed to geometric averages. The effect of these choices is summarized in table 4.2, which uses returns from 1928 to 2003. 11

Table 4.2: Historical Risk Premia for the United States - 1928- 2003

Stocks - Treasury Bills

Stocks - Treasury Bonds

9 The compounded return is computed by taking the value of the investment at the start of the period (Value0) and the value at the end (ValueN) and then computing the following:

Geometric Average =

Value0 %

Retirement Planning For The Golden Years

Retirement Planning For The Golden Years

If mutual funds seem boring to you, there are other higher risk investment opportunities in the form of stocks. I seriously recommend studying the market carefully and completely before making the leap into stock trading but this can be quite the short-term quick profit rush that you are looking for if you am willing to risk your retirement investment for the sake of increasing your net worth. If you do choose to invest in the stock market please take the time to learn the proper procedures, the risks, and the process before diving in. If you have a financial planner and you definitely should then he or she may prove to be an exceptional resource when it comes to the practice of 'playing' the stock market.

Get My Free Ebook

Post a comment