# Basic Question

If you underestimate the Equity Risk premium (for example you used a low value for Rf or inflation), would that lead to an overallocation or under allocation to equities ?

Overvaluation, as the denominator will be less givign a higher valuation.

Lower equity risk premium will lead to higer expected return (assuming all else hold constant). Higer expected return will lead to overallocation to equity.

ws Wrote: ------------------------------------------------------- > Lower equity risk premium will lead to higer > expected return (assuming all else hold constant). > Higer expected return will lead to overallocation > to equity. How will a lower ERP lead to a higher expected return ? in the simplest form: Expected Return = Risk Free + Equity Risk premium

Cool…let me clear some… Using DDM P0=D1/(r-g) a lower ERP will yield a lower required rate of return, r. How about now??

ws Wrote: ------------------------------------------------------- > Cool…let me clear some… > > Using DDM > > P0=D1/(r-g) > > a lower ERP will yield a lower required rate of > return, r. > > How about now?? Cool … Let me reply to this. in your equation a LOWER ERP ® will lead to a higher CURRENT price, this will DECREASE the expected return (as equity price increase the expected return decrease).

WS is saying the Lower ERP will lower Required rate of return, which will increase the Expected future Price and hence have a Higher Expected Return. If the stock is \$20 and my required return is artifically low so it suggests the stock should be \$50, my expected return would be 150%, but if I used a higher ERP the price might only be \$25 or a 25% expected return.

The underestimated ERP would lead to an underestimated expected return on equity (thru CAPM: r(e) = rf + ERP). If you are working in a mean-variance framework, this would lead to an under-allocation in equity. If you use an accurate measure of standard deviation, your Sharpe ratio for equities will be lowered due to the (mistakenly) lower expected return on equities. Equities would appear to have less return for any given unit of risk, and the equity allocation generated from most models will reflect that. I guess it depends on how you use the premium.

I misread the original question and was referencing a single stock. For a portfolio, the lower ERP would undervalue the Expected Return on Equities and hence one would Underallocate/underweight Equities in the portfolio b/c of the lower expected return and most likley lower Sharpe as Montana suggested.

joemontana Wrote: ------------------------------------------------------- > The underestimated ERP would lead to an > underestimated expected return on equity (thru > CAPM: r(e) = rf + ERP). > > If you are working in a mean-variance framework, > this would lead to an under-allocation in equity. > If you use an accurate measure of standard > deviation, your Sharpe ratio for equities will be > lowered due to the (mistakenly) lower expected > return on equities. Equities would appear to have > less return for any given unit of risk, and the > equity allocation generated from most models will > reflect that. > > I guess it depends on how you use the premium. Agree with that 100%. You can also use fancier models like the Singer-whatever or the other guys Kroner-and-friends … They all will lead to a lower expected return and lower allocation to equity.

What was the Singer -Tehaar or whatever model about? I just read it a couple days ago and don’t remember :((((

That was if I remember… Divident Yield - Change in Shares Outstanding + Inflation + ERP + Change in P/E or something along those lines…

That was the Grinold-Kroner model…

The singer one is the one where you have full segmentation and full integration and you weight both values for Equity Risk Premium. then add a liquidity premium and you’re done .

DAMNIT! At least I remembered something even if it was wrong.

Yep

Was I right on the Equation though for GK model?

^ Sorry, your equation there doesn’t look right. ERP (equity risk premium) wasn’t in that one. E®=Dividient yield+i+g-change of outstanding share+change of PE.

YEs Growth…damnit!!! I would have figured that out if growth was in the qeustion

But still, what is the Singer-Tehraan model? ('I’m not sure if it is Tehraan - whatever!)