Productivity at your daily life

Given a current 10-year T-bond rate of around 4.24 percent, the estimated forward-looking risk premium from this approach is about 10.97
4.24  6.73 percent. The second approach is to assume the forecasted earnings growth rate will equal the dividend growth rate.9 Using this growth estimate, you could estimate the required return on the market and the forward-looking risk premium as shown above. In recent years, estimates of the forward-looking risk premium have usually ranged from 4.5 to 6.5 percent, depending on the date of the estimate and the data sources used by the analyst.

Our View on the Market Risk Premium

After reading the previous sections, you might well be confused about the correct market risk premium, since the different approaches give different results. Using the historical Ibbotson data over the last 75 years, it appears that the market risk premium is somewhere between 5.7 and 7.3 percent, depending on whether you use an arithmetic average or a geometric average. However, in the past 30 to 40 years, the historical premium has been in the range of 5 to 6 percent. Using the forward-looking approach, it appears that the market riskpremiumis somewhere in the area of 4.5 to 6.5 percent.To further muddy the waters, the previously cited survey indicates that 37 percent of responding companies use a market risk premium of 5 to 6 percent, 15 percent use a premium provided by their financial advisors (who typically make a recommendation of about 7 percent), and 11 percent use a premium in the range of 4 to 4.5 percent. Moreover, it has been toward the low end of the range when interest rates were high and toward the high end when rates were low.

Here is our opinion. The risk premium is driven primarily by investors’ attitudes toward risk, and there are good reasons to believe that investors are less risk averse today than 50 years ago. The advent of pension plans, Social Security, health insurance, and disability insurance means that people today can take more chances with their investments, which should make them less risk averse. Also, many households have dual incomes, which also allow investors to take more chances. Finally, the historical average return on the market as Ibbotson measures it is probably too high due to a survivorship bias. Putting it all together, we conclude that the true risk premium in 2002 is almost certainly lower than the long-term historical average of more than 7 percent. But how much lower is the current premium? In our consulting, we typically use a risk premium of 5.5 percent, but we would have a hard time arguing with someone who used a risk premium in the range of 4.5 to 6.5 percent. The bottom line is that there is no way to prove that a particular risk premium is either right or wrong, although we are extremely doubtful that the premium market is less than 4 percent or greater than 7 percent.

Taken From : Credit Repair by Attorneys Robin Leonard and Deanne Loonin

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