Breaking News
0
Ad-Free Version. Upgrade your Investing.com experience. Save up to 40% More details

Risk Premia Forecasts: Major Asset Classes | 4 February 2020

By James PicernoStock MarketsFeb 04, 2020 10:13AM ET
www.investing.com/analysis/risk-premia-forecasts-major-asset-classes--4-february-2020-200504258
Risk Premia Forecasts: Major Asset Classes | 4 February 2020
By James Picerno   |  Feb 04, 2020 10:13AM ET
Saved. See Saved Items.
This article has already been saved in your Saved Items
 

The expected risk premium for the Global Market Index was steady in January after edging higher in recent months. Today’s revised estimate leaves GMI’s long-term ex ante return at an annualized 5.0% (before factoring in a “risk-free” rate).

GMI’s current projection matches last month’s 5.0% forecast and is moderately above the year-ago estimate (4.5%). GMI is an unmanaged, market-value-weighted portfolio that holds all the major asset classes (except cash) and represents the optimal portfolio for the average investor with an infinite time horizon. Accordingly, GMI can be used as a baseline starting point for asset allocation research.

Adjusting for short-term momentum and medium-term mean-reversion factors (defined below) reduces GMI’s current ex ante risk premium to an annualized 4.6%.

Expected Vs Trailing Risk Premia
Expected Vs Trailing Risk Premia

Note, too, that today’s GMI’s performance forecast remains moderately below the historical return based on the trailing 10-year period through last month. The benchmark earned an annualized 6.9% risk premium for the decade through January — moderately above the current unadjusted 5.0% long-run projection. The spread implies that investors should maintain a relatively cautious outlook on GMI (and other multi-asset-class strategies) vs. results for the decade that just ended.

All forecasts are likely to be wrong to some degree, but the projections for GMI are expected to be somewhat more reliable vs. the estimates for the individual asset classes. Predictions for the market components are subject to greater uncertainty compared with aggregating forecasts, a process that may cancel out some of the errors through time.

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 current 10-year performance (red line) has recently pulled back after surging to over 8%.

GMI Rolling 10 Yr Annualized Historical Risk Premia
GMI Rolling 10 Yr Annualized Historical Risk Premia

Now let’s turn to a summary of the methodology and rationale for the estimates above. The basic idea is to reverse engineer expected return, based on risk assumptions. Rather than trying to predict return directly, this approach relies on the moderately more reliable model of using risk metrics to estimate the performances of asset classes. The process is relatively robust in the sense that forecasting risk is slightly easier than projecting return. With the necessary data in hand, we can calculate the implied risk premia with the following inputs:

● an estimate of GMI’s expected market price of risk, defined as the Sharpe ratio, which is the ratio of risk premia to volatility (standard deviation).

● the expected volatility (standard deviation) of each asset

● the expected correlation for each asset with the overall portfolio (GMI)

The estimates are drawn from the historical record since the close of 1997 and are presented as a first approximation for modeling the future. The projected premium for each asset class is calculated as the product of the three inputs above. GMI’s ex ante risk premia is computed as the market-value-weighted sum of the individual projections for the asset classes.

The framework for estimating equilibrium returns was initially outlined in a 1974 paper by Professor Bill Sharpe.

We need not assume that markets are always in equilibrium to find an equilibrium approach useful. Rather, we view the world as a complex, highly random system in which there is a constant barrage of new data and shocks to existing valuations that as often as not knock the system away from equilibrium. However, although we anticipate that these shocks constantly create deviations from equilibrium in financial markets, and we recognize that frictions prevent those deviations from disappearing immediately, we also assume that these deviations represent opportunities. Wise investors attempting to take advantage of these opportunities take actions that create the forces which continuously push the system back toward equilibrium. Thus, we view the financial markets as having a center of gravity that is defined by the equilibrium between supply and demand. Understanding the nature of that equilibrium helps us to understand financial markets as they constantly are shocked around and then pushed back toward that equilibrium.

The adjusted risk premia estimates in the table above reflect changes based on two factors: short-term momentum and long-term mean reversion. Momentum is defined here as the current price relative to the trailing 10-month moving average. The mean reversion factor is estimated as the current price relative to the trailing 36-month moving average. The raw risk premia estimates are adjusted based on current prices relative to the 10-month and 36-month moving averages. If current prices are above (below) the moving averages, the unadjusted risk premia estimates are decreased (increased). The formula for adjustment is simply taking the inverse of the average of the current price to the two moving averages as the signal for modifying the projections. For example: if an asset class’s current price is 10% above it’s 10-month moving average and 20% over its 36-month moving average, the unadjusted risk premium estimate is reduced by 15% (the average of 10% and 20%).

What can you do with the forecasts in the table above? You might start by considering if the expected risk premia are satisfactory… or not. If the estimates fall short of your required return, you might consider how to engineer a higher rate of performance by way of customizing asset allocation and rebalancing rules. Keep in mind that GMI’s raw implied risk premia are based on an unmanaged market-value weighted mix of the major asset classes. In theory, that’s the optimal asset allocation for the average investor with an infinite time horizon. Unless you’re a foundation or pension fund, this time-horizon assumption is impractical and so there’s a reasonable case for a) modifying Mr. Market’s asset allocation to suit your particular needs and risk budget; and b) adding a rebalancing component to your investment strategy.

You might also estimate risk premia with alternative methodologies for additional insight about the near-term future. For instance, let’s say that you have confidence in the dividend-discount model (DDM) for predicting equity market performance over the next 3 to 5 years. After crunching the numbers, you find that DDM tells you that the stock market’s expected performance will differ by a considerable degree vs. the equilibrium-based estimate for the long run. In that case, you have some tactical information to consider.

Keep in mind, too, that combining forecasts via several models may provide a more reliable set of predictions vs. estimates from any one model. Indeed, a number of studies published through the years document that combined forecasts tend to be more robust vs. single-model projections.

What you can’t do is get blood out of a stone. No one really knows what risk premia will be in the months and years ahead, which is why relying on forecasting alone (particularly for the short-term future) is asking for trouble. In other words, you should deviate from Mr. Market’s asset allocation carefully, thoughtfully, and for reasons other than assuming that you’re smarter than everyone else (i.e., the market).

Risk Premia Forecasts: Major Asset Classes | 4 February 2020
 

Related Articles

Risk Premia Forecasts: Major Asset Classes | 4 February 2020

Add a Comment

Comment Guidelines

We encourage you to use comments to engage with other users, share your perspective and ask questions of authors and each other. However, in order to maintain the high level of discourse we’ve all come to value and expect, please keep the following criteria in mind:  

  •            Enrich the conversation, don’t trash it.

  •           Stay focused and on track. Only post material that’s relevant to the topic being discussed. 

  •           Be respectful. Even negative opinions can be framed positively and diplomatically. Avoid profanity, slander or personal attacks directed at an author or another user. Racism, sexism and other forms of discrimination will not be tolerated.

  • Use standard writing style. Include punctuation and upper and lower cases. Comments that are written in all caps and contain excessive use of symbols will be removed.
  • NOTE: Spam and/or promotional messages and comments containing links will be removed. Phone numbers, email addresses, links to personal or business websites, Skype/Telegram/WhatsApp etc. addresses (including links to groups) will also be removed; self-promotional material or business-related solicitations or PR (ie, contact me for signals/advice etc.), and/or any other comment that contains personal contact specifcs or advertising will be removed as well. In addition, any of the above-mentioned violations may result in suspension of your account.
  • Doxxing. We do not allow any sharing of private or personal contact or other information about any individual or organization. This will result in immediate suspension of the commentor and his or her account.
  • Don’t monopolize the conversation. We appreciate passion and conviction, but we also strongly believe in giving everyone a chance to air their point of view. Therefore, in addition to civil interaction, we expect commenters to offer their opinions succinctly and thoughtfully, but not so repeatedly that others are annoyed or offended. If we receive complaints about individuals who take over a thread or forum, we reserve the right to ban them from the site, without recourse.
  • Only English comments will be allowed.

Perpetrators of spam or abuse will be deleted from the site and prohibited from future registration at Investing.com’s discretion.

Write your thoughts here
 
Are you sure you want to delete this chart?
 
Post
Post also to:
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Thanks for your comment. Please note that all comments are pending until approved by our moderators. It may therefore take some time before it appears on our website.
 
Are you sure you want to delete this chart?
 
Post
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Add Chart to Comment
Confirm Block

Are you sure you want to block %USER_NAME%?

By doing so, you and %USER_NAME% will not be able to see any of each other's Investing.com's posts.

%USER_NAME% was successfully added to your Block List

Since you’ve just unblocked this person, you must wait 48 hours before renewing the block.

Report this comment

I feel that this comment is:

Comment flagged

Thank You!

Your report has been sent to our moderators for review
Disclaimer: Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. All CFDs (stocks, indexes, futures) and Forex prices are not provided by exchanges but rather by market makers, and so prices may not be accurate and may differ from the actual market price, meaning prices are indicative and not appropriate for trading purposes. Therefore Fusion Media doesn`t bear any responsibility for any trading losses you might incur as a result of using this data.

Fusion Media or anyone involved with Fusion Media will not accept any liability for loss or damage as a result of reliance on the information including data, quotes, charts and buy/sell signals contained within this website. Please be fully informed regarding the risks and costs associated with trading the financial markets, it is one of the riskiest investment forms possible.
Continue with Google
or
Sign up with Email