The projected risk premium for the Global Market Index (GMI) ticked higher in May. GMI, an unmanaged market-value weighted mix of the major asset classes, is expected to earn an annualized 5.4% (over the “risk-free†rate) in the long run – 20 basis points above last month’s estimate.
Adjusting for short-term momentum and longer-term mean-reversion factors (defined below) trims GMI’s ex ante risk premium to an annualized 5.0%, which is slightly above the 4.9% estimate in the previous forecast.
Meanwhile, the trend for GMI’s risk-premium performance in recent history held steady May. The benchmark earned an annualized 4.3% for the three years through last month, unchanged from pace through April.
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Here’s a recap of how GMI’s risk premium estimates have evolved over the last three years:
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Next, let’s turn to actual performance in recent history: here’s a chart of rolling three-year annualized risk premia for GMI, US stocks (Russell 3000) and US Bonds (Bloomberg Barclays Aggregate Bond Index) through last month.
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Finally, here’s a summary of the methodology and rationale for the estimates above. The basic idea is to reverse engineer expected return based on assumptions about risk. Rather than trying to predict return directly, this approach relies on the somewhat more reliable model of using risk metrics to estimate performance 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 estimate the implied risk premia using 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).
â— the expected volatility (standard deviation) of each asset
â— the expected correlation for each asset with the overall portfolio (GMI)
