Recommended Reading

I never completed my previously promised series on the equity risk premium, but for readers who are interested in the topic I would highly recommend the recently released “Rethinking the Equity Risk Premium” from the CFA Institute.

This free PDF contains a variety of interesting perspectives on the future of the equity risk premium. Note that a print version of the book is available on Amazon, and Kindle users can download a version formatted for Kindle for just $1.

Key Takeaway

The book has analyses from both academics and practitioners, and a variety of estimation methods are used. In my opinion, the key takeaway is that nearly all of the experts forecast future equity returns which are lower than the historical averages. Several well-argued forecasts put expected nominal equity returns in the 6%-7% per year range.

The key reason for the lower forecasts is simple. Equity valuations are higher than their average historical level. This leads to lower yields, and less potential for capital gains from further expansion of P/E ratios. Lower yields and less potential for growing valuation multiples mean that higher earnings growth must pick up the slack. Several authors provide reasons why higher-than-historical earnings growth is unlikely.  Many measurable factors actually suggest lower future economic growth (demographics, debt levels, scarce resources), and economic growth is closely linked to earnings growth. I found much of the analysis to be very convincing, though not especially uplifting!

Implications for Investors

My thoughts after reading this document are that few investors saving for retirement are prepared for equity risk premiums and real returns as low as those suggested by many of these experts. The experience of the 80s and 90s led many investors to believe that setting aside a relatively modest sum each year would lead to a comfortable nest egg by the time retirement came around. The last decade has certainly made individual investors more pessimistic about investing returns, but I’m not sure how many fully understand the impact of lower returns on their investing goals.

The table below illustrates the amount of annual savings needed to reach a one million dollar retirement goal at several different levels of nominal annual return. This simple example assumes that an investor starts saving at age 25 and continues making annual contributions through age 65 (41 contributions).  I assume that payments are made at the beginning of each year.

 

Expected Return	Target FV Amount	Required Annual Contribution
10%	$1,000,000.00	$1,863.36
8%	$1,000,000.00	$3,297.68
6%	$1,000,000.00	$5,715.90
4%	$1,000,000.00	$9,632.09
2%	$1,000,000.00	$15,658.71

Continue reading »