Stacking Risk Premiums: Predicting Future Stock Market Returns

All investments have risk, even supposedly “risk-free” assets like US Treasury Bills.  For practical purposes, however, the yield on the 90-day US Treasury Bill is often referred to as the risk-free rate because the risk of these securities, while not quite zero, are extremely close.  According to Investopedia, the risk-free rate is

“…the minimum return an investor expects for any investment because he or she will not accept additional risk unless the potential rate of return is greater than the risk-free rate.”

I you are going to invest in a risky asset with the potential to lose money, it has better promise to pay more than the risk-free rate.  Otherwise, why would you take the risk to begin with?

Stacking Risk Premiums

It is important to note that even though the yearly returns of stocks, bonds, real estate, and other asset classes fluctuate wildly over the short term, their volatility relative to each other is much more consistent.  In other words, while there are periods when bonds out-perform stocks, over the long term, the risk premium for owning stocks has remained more steady.  Each asset class has its own set of risk premiums over the risk-free rate.  For example, high-quality, intermediate-term corporate bonds carry a minor credit risk premium of say 0.4% as well as a modest term premium of an additional 0.2% to account for the risk that inflation may flare up before maturity.  Since these bonds carry more risk than T-bills, they must pay a higher return.  Otherwise, nobody would buy them when they could get the same return for less risk elsewhere.  By adding risk premiums on top of each other, we can get a good idea of what future returns might look like for any given asset class.  For example, the return of short-term investment grade corporate bonds is likely to work out as follows:

  Short-term Investment grade Corp bonds = T-Bill + credit risk premium

Similarly, the return of lower-quality, high-yield corporate bonds (or junk bonds), are likely to approximate

High-yield Corp Bonds = T-Bill + credit risk premium + junk bond default risk premium

There is also an equity risk premium.

U.S. Large-cap Stock Returns = expected corp bond returns + equity risk premium

These risk premiums continue on down the line to a size premium (for small-cap stocks) as well as a value premium (for out-of-favor stocks).

Projecting Future Returns

Since the risk-free rate is known at any given time (just check the yield on the 90 day Treasury Bill), we can project future returns of the various asset classes by stacking their various risk premiums.

Example of Stacking Risk Premiums

Of course, the premiums in this table are just estimates based on historical data.  Future risk premiums aren’t likely to be exactly the same as in the past, but they should be close.  It should also be noted that this method tends to break down a bit during periods of rapidly increasing inflation or unstable capital markets since it depends on the real after-tax return of risk-free T-Bills being approximately zero.  So while you wouldn’t want to bet the farm that small-cap value stocks will return 9.8% over the next 30 years, you can be reasonably sure they will return 1-2% more than large-cap stocks over the long-term, albeit with a commiserate increase in risk  The data for this chart was taken from All About Asset Allocation by Richard Ferri.  He dedicates an entire chapter to forecasting and goes into much more detail than I have here.  It is well worth a read by any investor.

This is part one in a series on predicting future stock market returns.

• Introduction: Predicting Future Stock Market Returns
• Part 2:  Forecasting Stock Returns Using Macroeconomic Growth Factors