Thursday, May 7, 2009

What do Finance Professors think the equity premium is?

A recent survey shows that in the US, Finance professors think that the equity premium is on average about 6.3%.

I actually participated in the survey and I think I said 6%. Of course more recently, the premium has certainly been higher, although before the credit market problems, I think it was headed lower than 6%.

If it is 6%, then what does this mean? Well, if the long term bond rate is about 3%, then the expected return on large cap stocks should be about 9%.

I have no idea whether or not 6% is the right number, but I am pretty sure about is that at current bond rates, a long term expected return on stocks of 12% (the historic nominal mean) is delusional.

The difference between 12% and 9% is massive.

$1000 per month for 30 years at 9% will grow to $1,830,743. While the same investment at 12% will grow to $3,494,964. Of course this assumes that the investment doesn't grow. The point is that if your financial plans are based on 12%, then you better hope that your kids are smart, because you're going to have to rely on them to pay for your retirement!