Risk premium rumble

03Oct06

If it is not clear by now we are big fans of the work over at CXO Advisory Group. They do an admirable job of highlighting new and interesting academic research with an emphasis on actionable insights. The value of academic research comes not only from the results found, but in the questions asked.

In a recent post CXOAG reviews a paper that surveys recent research into the equity risk premium, or ERP. It is important to note that there are indeed a number of different flavors of ERP and the paper discusses the relevant differences between them. We suggest interested readers check out both the paper and the summary.

In a sense, there is nothing more fundamental to the practice of finance than the equity risk premium. An estimate of the ERP is required for all manner of investment analysis and corporate finance. Without some idea of our required return for the market as a whole we cannot derive reasonable assumptions for the valuation of companies, nor can we conduct an asset allocation exercise.

The funny thing is that academic finance has had a difficult time coming up with a consistent definition of the historical equity risk premium and a more difficult time deriving a forward-looking estimate. We will leave the discussion of this to the paper itself, but this situation does merit a comment.

In short, the output from academic finance, while valuable, should be viewed with a measure of skepticism. If academics cannot agree on something so fundamental, then what should we believe? However, just because some professors disagree on a topic does not mean we should throw out their work without due consideration. The only way we can advance our understanding of the world around us is through rigorous research, based in the scientific method.

Not surprisingly there are disputes in academic finance over theory, data and methodology. That only magnifies the importance of understanding the underlying assumptions and processes used in any particular piece of research. While headlines may attract the most attention, it is often the guts of a paper that truly tell the tale.

The fact is that no one said this whole investing thing would be easy. The point is that it is hard. If it was easy then everyone and their brother would already have a hedge fund.  Oh wait, they already do

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