Running the Risk Premiums

 |  Includes: DIA, QQQ, SPY, TIP
by: James Picerno

What should we expect from Mr. Market? The answer's always in doubt, but strategic-minded investors should run through the numbers anyway.

It's hard to overrate the value of taking a hard look at investing assumptions. By continually putting an expected price on risk, we become better investors. There are no crystal balls, but the next best thing is improving our skills in the art and science of discounting the future as a tool for enhancing return…maybe.

As an example, in the next issue of The Beta Investment Report we forecast an expected equilibrium risk premium for the market portfolio of 2.5%. We arrive at that forecast from summing up the individual forecasts for each of the major asset classes based on their market-cap-informed share of the total portfolio. Overall, it's a long-term prediction based on an equilibrium assumption and, we believe, a reasonable benchmark forecast, for reasons we discuss in some detail in the newsletter. But we can't be sure that our forecast is accurate and so we need to stress test our assumptions a bit. Here's a very brief illustration of the basic concept, including some of the give and take that keeps us forever wondering about what's coming.

If we assume a 3.0% risk-free rate for 3-month T-bills, our 2.5% risk premium forecast for the market portfolio becomes a 5.5% annualized total return outlook. But that's nominal. We also need an inflation forecast for estimating our real, or inflation-adjusted return.

Let's be generous and assume that inflation will be modest 2.0% going forward. That's a bit higher than the market's 1.8% inflation expectation, based on the spread between the yields on the nominal and inflation-indexed 10-year Treasury Notes. Yet 2.0% inflation is also below the 3.0% inflation that prevailed during the 20 years of the Great Moderation through 2008.

Putting it all together, expecting 2.0% inflation and a 5.5% nominal total return for the market portfolio leaves us with a 3.5% real annualized total return. But let's remember that forecasting is difficult, especially about the future, as the old saw goes. As such, we should assume that our predictions are subject to error. The question is how much error?

If inflation ends up at 3.0% instead of 2.0%, our real return falls to 2.5%. At 5.5% inflation, our real return is zero.

But perhaps actual inflation will be lower than our expectations. Or perhaps our risk premium projection of 2.5% will be higher. Meanwhile, a confident investor might project a higher return by skewing his asset allocation to, say, U.S. stocks because he thinks returns there will exceed the market portfolio's expected risk premium.

Then again, let's consider another alternative. We could buy a 20-year TIPS and lock in the real return of 2.42%, based on last night's close. That's nearly as high as our market portfolio risk premium forecast, which is a nominal return. Why is the TIPS market offering what appears to be a high real return? Are TIPS prices too low? Or is our risk premium outlook too low?

There are no definitive answers if we're looking forward. But until we start plugging in the numbers and making assumptions, the difficult business of making investment decisions is that much tougher. In a perfect world, we could simply extrapolate historical returns into the future. That would make our job as investors rather easy. Alas, it's not quite so simple. Historical returns are a volatile lot and it's not clear which historical period applies to the immediate future that awaits.

What should we do? Before we can begin making judgments about asset allocation, we need a neutral (or minimally biased) reference point for assessing the market outlook. In short, we need an estimate of equilibrium risk premiums for individual asset classes and the portfolio overall. From this foundation, we can amend the market-inspired asset allocation based on our risk preferences and expectations.

Estimates of equilibrium risk premium offer a basis for adjusting the asset allocation, if at all. Expecting that future returns will deviate from the implied equilibrium predictions in the short-to-medium term suggests changing the passive market-cap asset allocation. For instance, let's say that an investor is quite a bit more bullish on U.S. stocks for the next 3-5 years compared with the assumption in the long-run equilibrium risk premium forecast. Adapting that view into an asset allocation strategy translates into raising the U.S. equity weight over the market-cap weight; a more bearish perspective calls for a lower-than-average market-cap weight.

Most investors should probably accept the market-cap weight; in practice, almost no one does. Then again, that probably explains why the market portfolio's track record looks pretty good over time relative to actual portfolio results. To understand why, we need to make some assumptions beyond risk and return by also considering taxes and trading costs.

Beating the market is hard, in part because making accurate predictions is difficult. But even forecasts that are reasonable are in danger of being irrelevant, or worse, once we factor in the cost of trading and paying the government, say, one-third of any profits. That implies that we need more than reasonably good predictions to overcome the frictions that harass actual portfolios; we probably need stellar forecasts. No wonder that alpha's so scarce.