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Additional resources for The Risk Premium Factor, + Website: A New Model for Understanding the Volatile Forces that Drive Stock Prices

Sample text

This method is very sensitive to the dates selected for measuring the growth, since different periods show different returns. Because the goal is to measure expectations, some argue that recent periods are more relevant, while others argue that using long-term return going back to the 1920s is the best measure. There is also disagreement on whether to use geometric or arithmetic means for calculation. The geometric method uses the difference in compound growth rates, while the arithmetic takes the annual returns in each year, then averages them.

Earnings, while not ideal, are used as a proxy for cash flow and seem to work very well. G = Expected long-term projected growth rate, which is broken down into its components of real growth and inflation, so G = GR + ILT . GR = Expected long-term real growth rate. Long-term expected real growth rate (GR ) is based on long-term gross domestic product (GDP) growth expectations on the basis that real earnings for a broad index of large-cap equities will grow with GDP over the long term. 1 IntR = Expected real interest rate (IntR ) is 2%; based on the average 10-year Treasury Inflation-Protected Securities (TIPS) Yields from March 2003 to the present2 .

My own experience is that organizations without such incentives tend to be very risk averse. When decisions come down, the internal calculus that investing successfully results in no reward, where failure is career limiting or results in unemployment, investment and growth are sure to slow. I would argue also that this explains risk taking for traders on Wall Street, where outsized rewards are given for success compared to the more limited stigmas or punishments for failure. It’s not that traders need high tolerance for risk, it’s that when using OPM (other people’s money), the penalty for failure is small.

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