Future investment returns

Some nice discussion related to equity risk premia in the Economist. "...Despite the slump in prices in the three years to 2002, price-earnings (p/e) ratios still look a bit high, notably on American shares, and share valuations are unlikely to benefit from falling interest rates in future. Meanwhile, lower inflation means that the pace of profits growth will slow. Assume that America's nominal GDP grows by 5% a year (3% in real terms, plus 2% for inflation). If the share of profits in GDP is constant, profits will grow at the same rate. However, profits could do much less well, because in America, Japan and the euro area their share of GDP is close to a record high. They might well be expected to fall.

Suppose, though, that profits do rise in line with GDP and that p/e ratios stay the same. Then, Mr Barnes estimates, the total nominal return on American shares over the next decade will average 6.8% (5% profits growth, plus dividends), half the figure for the past 20 years. If profit margins fall modestly and the p/e ratio reverts to its long-term average, returns will average 4.9%—well below investors' expectations. Surveys suggest that individuals expect returns of more than 10%.

Could property instead lay the golden egg of the next decade? According to The Economist's global house-price indices, housing has yielded double-digit returns (including rental income) in most countries over the past 20 years. But the peak may be close. In several countries house prices are at record levels relative to incomes and rents. At best, they are likely to flatten off over the coming years. Add in the sharp fall in rental yields, and the prospective total return on property over the next five years or so is poor."

But, there is reason to believe that p/e ratios will remain higher than their historical average, due to investor confidence in the equity risk premium.