Allegedly, stocks generate, on average, higher real returns than bonds, that is, there is an equity premium.
The equity premium can be observed over certain time periods. For example, during the 1950s stocks outperformed bonds by 19 percent.
But I've never understood why there should be a large premium on equities.
Supposedly the equity premium compensates shareholders for the risks that they bear. But large institutional investors are able to hold a highly diversified portfolio, so variance in the performance of individual stocks should have little effect on their overall rate of return. If stocks had a higher return, on average, than bonds, surely any investor large enough to diversify risk would buy mostly stocks. This would bring up the price of stocks up until, in equilibrium, the returns to stocks would be close to the return to bonds.
And it's not as if bonds are risk-free, anyways. Bond issuers go bankrupt and default. Inflation happens. Interest rates go up and down.
It seems to me equally plausible that the equity premium was an artifact of the Great Depression, when the Dow Jones lost 89 percent of its value over a three year period. The gradual recovery of those losses during the 1950s, 60s and 70s could explain the equity premium observed in the data.
Alternatively, perhaps new technology and the emergence of large institutional investors in the 1970s, 1980s and 1990s allowed people to figure out how to diversify portfolios and manage risks, creating an increased demand for stocks, running up the value of equities. But now we're in a new equilibrium, with a much smaller, or non-existent equity premium.
Or perhaps it's demographics – the stock market boom was created by the savings of baby boomers, and now that the first boomers are starting to hit retirement age, it's all starting to fall apart (but it seems a bit early for that).
If the equity premium no longer exists, so what?
First, the standard investment advice – buy stocks when you're young, switch to bonds as you get older - would be wrong.
Second, if the return on stocks is no higher, or only very slightly higher, than the return on bonds, and the return on bonds is 1 or 2 or 3 percent a year, then every retirement plan that is based achieving a 4 or 5 or 6 percent real return each year has to go out the window.
To be quite honest with you, this is all just me talking off the top of my head. I know next to nothing about this subject. So this isn't so much a blog as a bleg. What do you think? Is there still an equity premium? Is the standard advice given to investors right or wrong? Are you buying or selling today? Or glued to a screen and watching the riots unfold? Or just watching cute animal videos on youtube?
Update: For a good non-technical introduction to the equity premium puzzle, see this survey piece by Brad DeLong and Konstantin Magin. They argue that "degree of risk aversion needed to support the existing equity return premium seems extremely high" – in other words, risk doesn't explain the equity premium. They discuss various other reasons (loss aversion, etc) why an equity premium might exist. Their article was written in 2008, right at the top of the market. At that time they predicted a continuing equity premium of about 4 percent. After the crash, they revised their prediction of the on-going equity premium upwards.
Such high returns on an on-going basis just seem to good to be true – and I would be astonished if the markets do indeed generate such high returns on equities.
Worthwhile Canadian Initiative 
Between the market top for the DOW in 1929 and the next major top in 2000, this index went from 400 to 1100 adjusted for inflation. This is 1.45% per year not including dividends and inflation. See http://www.dogsofthedow.com/dow1925cpilog.htm
Considering that our government has a tendency to undervalue the CPI, that the population growth is slowing and that the cheap energy is already gone, the future look bleak.
If you add to this that the DOW is constantly removing/adding companies, the typical mutual fund fee is 2-3%/yr and, let’s not forget, the debt vs GDP is much higher than in 1980 of 1929, I don’t see how a pension fund can assume a 6% rate of return.
Between 1929 and 1983, the DOW returned -1.7% (inflation adjusted).
“Allegedly, stocks generate, on average, higher real returns than bonds, that is, there is an equity premium.”
Um….why allegedly? There’s data on this isn’t there? You could like, you know, calculate averages. You could even ask someone who knows how to test whether their average returns are statistically different.
Or did you have something else in mind?
Simon: “Um….why allegedly? There’s data on this isn’t there?”
If you want to demonstrate that there’s an equity premium, start in 1932 and end at some point when the market is at a peak.
If you want to demonstrate that there isn’t an equity premium, start in 1929, and end at some point when the market is in a trough.
Whether or not you find an equity premium depends upon the time period one chooses for the analysis.
Moreover, just because historically there has been an equity premium doesn’t prove that there will be one going forward.
Normand – I’ll take that as a “no” vote on the equity premium.
Here’s a simple example of why you might want to buy stocks; consider the TD bank (ticker symbol TD.) Their stock (as of 2:18pm today) had a dividend yield of about 3.5%. That means that, if you bought the stock today and dividends stayed at the level they’ve been over the past, you would get $3.50 in dividend payments over the next year for every $100 you invested in the stock. If I instead buy a 1 yr Canadian Govt bond, I’ll get just under $1.20 for every $100 I invest. According to the Bank of Canada, yields on Canadian Govt. Bonds of any maturity are all under 3.5%.
Historically, however, stock prices tend to rise over time. That means that I should expect not just to earn the dividend yield, but I should also expect to make some capital gains. (On average. Your results may differ.)
If you think that there is no equity premium, then you need to explain why the expected return on, say TD stock is down around 1.2%. That means that you must be expecting (a) the price of the stock to fall, or (b) that dividends are going to be cut a lot, or (c) both. In fact, some people are arguing that the very low interest rates we see currently make stocks look unusually attractive, in the same way that standing next to someone very ugly makes people seem more attractive.
Frances: “just because historically there has been an equity premium doesn’t prove that there will be one going forward.”
Okay….so you want to allow for a time-varying equity premium; that’s fine (but not what your opening sentence says.)
Sold my TD.TO a couple of months back, after holding for decades. Agreed with my broker that they were, as he put it, “priced for perfection”. Did well to sell them then. Was vaguely thinking of buying them back yesterday. But couldn’t decide. Might still do so.
The best thing I read (or heard about) on the equity premium puzzle wasn’t even supposed to be about the equity premium puzzle. That recent study comparing owning vs renting a house in the US. It said renting was almost always better, historically. But one of the assumptions was that the money saved from renting was invested in stocks. So essentially it was comparing investing in stocks vs investing in housing. Stocks beat housing. No surprise. Stocks beat bonds too.
Simon: “That means that you must be expecting (a) the price of the stock to fall, or (b) that dividends are going to be cut a lot, or (c) both.”
Yes, that’s right. Since the TSX is basically unchanged from August 2006, and well down from previous peaks, (a) certainly sounds plausible enough if you’re thinking about the market in general.
But let’s take TD – it’s true, the dividend-paying stocks are the only ones on my screen that have that happy green writing beside them right now.
What if we are 99% confident that TD will continue to make the same dividend payments on an on-going basis. Then the sensible thing to do is to sell bonds and buy TD. TD stock values will soar. We’ll see an equity premium for a while.
Then what? We’re in a new equilibrium, where TD stock is worth, say, twice what it is right now. Going forward from there, will the equity premium continue? Why?
Simon – “but not what your opening sentence says.”
No, it’s in the title (Does the equity premium STILL exist?)
Simon,
Just a few days back, Yellow Media had a 35% dividend return. The share price keep falling and they finally cut the dividend from 0.65$ to 0,15$. That company is around for a very long time and most pension fund used to carry some of their shares. It could happen to any company, TD included.
I am following the 20 largest financial companies in the US since 2006. That list is now down to 9 (some went broke or are penny stock or in receivership). Out of those 9 you can count BAC, C, MS and WFC as bankrupt if normal accounting practises were back (market to market).
My broker offered me a 2% interest for all margins. For sure this has an influence on the market.
So for those of you who like fun and games with Excel, you can get high-quality long-term data on US stocks and bonds and inflation from Prof. Robert Shiller’s (of “Irrational Exhuberence” fame) web site at http://www.econ.yale.edu/~shiller/data/ie_data.xls
To compare stock returns to bond returns, I don’t have to worry about inflation (it affects them equally), so I’ll just compare stock and bond nominal returns. Stocks peaked in Sept. 1929 at 31.30 and troughed in March 2009 at 757.13; that gives me a compound annual rate of return of 3.9% excluding dividends. Including dividends gives me another 4.0% compound annual rate of return. Bonds (in this case, 10 year US Treasury Bonds) gave me 5.3%.
So even when I try to look at things the way that Frances suggests, I still get an equity premium of a few percent (or about 50% more than the return on bonds.)
Frances, why do you think that the premium is zero? Is there some evidence to back that view?
Frances, agreed that the equity premium seems an artifact now. But what happens if this becomes the new normal? No one will buy equity anymore.Why would you when a bond, which has senior payment priority, promises the same return? It would be impossible for any company to raise equity financing anymore. Unless they start paying a premium again.
First a little history. While we associate the late 1940’s and early 1950’s with a period of unparalleled prosperity, the stock market of the time didn’t reflect that. When looking at what market players and traders actually thought (some of them wrote about this time) the received wisdom was that there was going to be another Depression. The thought went that the Civil War was followed by the Panic of 1873 and the Long Depression, World War I was followed by the Great Depression and the latest war would be followed by a depression soon enough. Companies like Xerox whose business was booming trades a 3 times earnings. The P/E multiples of this time period were ludicrously low by today’s standards.
The Dow didn’t reach its high of 1929 until 1954. Further, please remember the Dow is not a proper index. It is a price-weighted list of 30 stocks. The S&P 500 is much broader and weighted by market capitalization and is generally considered a much better index methodologically speaking and a much better representation of US Equities and the market’s view thereof.
Simon – “why do you think that the premium is zero? Is there some evidence to back that view?”
I’m not saying that the premium in the past has been zero. I agree that there are periods over which one can observe an equity premium.
I’m questioning whether or not we can accept as gospel truth that the equity premium will continue to exist in the future. As I said in the post: “If stocks had a higher return, on average, than bonds, surely any investor large enough to diversify risk would buy mostly stocks. This would bring up the price of stocks up until, in equilibrium, the returns to stocks would be close to the return to bonds.”
As rogue says, there are still privileges to bond holding, which would justify a small equity premium. But do you sincerely, honestly, believe that stocks will continue to generate a 50% higher return than bonds going forward, indefinitely, forever? And given that firms will still choose to finance their undertakings through equities rather than bonds?
Norman: “Between the market top for the DOW in 1929 and the next major top in 2000, this index went from 400 to 1100 adjusted for inflation. This is 1.45% per year not including dividends and inflation. See http://www.dogsofthedow.com/dow1925cpilog.htm”
Sure, but if you’re excluding dividends, you’re excluding a big chunk of the return of the Dow, and equities more generally, over the past century(typically, for most of the past century, in excess of 4% a year).(see http://disciplinedinvesting.blogspot.com/2009/02/dividends-critical-component-of-total.html). That’s like measuring the return on bonds and ignoring interest payments.
Interestingly, during the 1980’s and 90’s, we saw a decline in the dividend yields of the major American stock indexes. I couldn’t tell you why that is (if you’re a pessimist, it’s because the market is still overvalued, if you’re an optimist, it’s because companies chose use retained earnings to boost shares prices, either through investment, or through share buy backs). I would not be the least bit surprised, though, if we don’t see that trend reverse over the next decade.
Frances:
I sincerely, honestly expect that from today onwards stocks will have a higher rate of return than bonds, and that it will quite a bit larger than what is indicated by those calculations I did (which you’ll recall you designed to give the lowest possible return for equities.)
I do not agree that “…in equilibrium, the returns to stocks would [or should] be close to the return to bonds.” This is because (a) I think stocks add more risk to a diversified portfolio than bonds, and (b) investors are risk averse, so (c) they need an equity premium to entice them to hold stocks in their portfolios.
Yes, that premium may vary through time. This afternoon, I think many investors have decided that stocks are riskier than they realized, so they are requiring a larger equity premium on stocks going forward. If you think we’re in equilibrium right now, I think you should expect a higher, not a lower, equity premium looking forward. (No, I have no idea whether we’re in equilibrium.)
Didn’t most countries, especially the US, UK and Canada engage in “Capital Repression” until the 1960’s? The US debt-to-GDP ratio in 1948 was 120%. The US Treasury actually had to sit down and negotiate a deal with the Federal Reserve in 1948 to keep interest rates low, specifically for the short term so the US could begin to pay down its debt without facing higher interest costs but more generally because it allowed the debt to be managed through inflation and economic growth, both of which were enhanced by low interest rates.
With interest rates suppressed no wonder equities looked good. But interest rates are no longer repressed like that so it stands to reason equities and bonds should converge.
Isn’t there a fundamental problem with trying to determine whether there is an “equity premium” on a retrospective basis? Isn’t the equity premium an inherently prospective concept.
For example, my return on Yellow Media has been, thus far , far (far, far, far) less than the return on US treasuries that I might have invested in. But I didn’t buy Yellow Media units on the expectation that their price would plumet precipitously (although I recognized that as a risk), I bought Yellow Media units on the expectation that they would outperform US treasury bills by a sufficiently high margin to ouweight the risk that they might not. Had you offered me Yellow Media units with an expected return of 1% (or whatever the US government is paying these days), I’d have told you to get stuffed. That’s the equity premium.
The fact that investors (and the market generally) might made investment decisions that, with the benefit of hindsight, were wrong (i.e., in 1929, stocks were badly overvalued, in 1950, they were badly undervalued), doesn’t prove that there isn’t an equity premium.
And while I agree with Frances that bonds carry their own risks (some common to stocks, i.e., bankruptcy, others distinct from stocks, perhaps inflation), I don’t think it’s absurd to say that they are, as a class, less risky than stocks (since the latter is entitled to a fixed, and preferred, income payout and gets priority in bankcruptcy, liquidation, etc.). It might be interesting to look at the environment of large corporate issuers, and compare the returns on bonds, stocks, and various hybrid instruments with different degrees of debt/equity features (preferred shares, convertible debentures, etc.). You would expect to see the expected return at the time of issuance on those various instruments increase fairly smoothly as you move from the equity to debt side of the spectrum – although that may be complicated by inconsistent tax treatment of form of capital income.
Bob, I agree on the inherently prospective nature of the equity premium.
On risk premia:
The Canada Pension Plan Investment Board, according to its latest investment report, has $148 billion worth of assets. http://www.cppib.ca/Investments/Total_Portfolio_View/. You can’t diversify away risk. I can’t diversify away risk. But surely the CPP should be able to diversify away risk.
If there’s an equity premium, the CPP investment board and any other investor with vast amounts to invest over a long time period should buy only stocks. Increasing demand for stocks. Raising the price of stocks. Until the only equity premium that remains reflects the risks that can’t be diversified away by a $148 billion dollar long term investment fund – i.e. a very low level of risk.
Frances, you might want to take a look at The Cross-Section of Volatility and Expected Returns (Ang et al, 2006). I presented their findings in the financial econometrics class this past winter and what they argue is that while there is a return on stocks with idosyncratic volatilities greater than government bonds after a certain point portfolios with high volatilities show returns that are lower than theory would predict. What me and professor Wan concluded was that portfolios at the high end were being purchased by people that simply lacked the knowledge to properly price portfolio returns, ie investors that liked to gamble with their investments.
Now the data we were looking at was from before the recession but its quite plausible that if we are in a time global uncertainty there will be no market actors that can properly price risk and therefore there will be no equity premium.
“But interest rates are no longer repressed like that so it stands to reason equities and bonds should converge”
Really? You think US Treasury yields can be repressed much more than the 0.01% yield they’re currently paying on 90-day bonds? Today’s 10-year bond rate is roughly the same, or lower, than the 10-year bond rate through the 1940’s and the 1950’s.
“The Canada Pension Plan Investment Board, according to its latest investment report, has $148 billion worth of assets. http://www.cppib.ca/Investments/Total_Portfolio_View/. You can’t diversify away risk. I can’t diversify away risk. But surely the CPP should be able to diversify away risk.”
Isnt there always going to be some amount of market risk that can never be diversified away unless you invest in government bonds?
Compared the the price inflation, wage increases and general economic growth being exhibited? In the 1950’s we had strong growth with low interest rates. Now we have anemic growth with low interest rates.
So interest rates were low in 1950’s compared to the rate of return offered by the economy, while today the interest rate is much higher compared to the economy’s rate of return.
I am right if I say: Planet earth taken as a whole, productivity gains being neglected, the expected return on all assets (bond, stocks, GIC, etc) is the inflation rate, or 0% inflation adjusted.
Otherwise we are getting richer by printing more dollars which only means more inflation. Or where is that wealth coming from?
This is assuming a long enough time frame.
Does this make sense for a bunch of economists?
There are two arbitrage conditions, the (nominal) return on capital versus bonds, where the latter is a policy variable, and Tobin’s Q. I don’t see why the two must give the same price — so there will be some form of arbitrage available. But the arbitrage is limited — let’s say households can only borrow against collateral when they want to purchase capital, and that as household leverage increases, they demand a higher spread in order to engage in the arbitrage, etc. Pick your favorite credit friction.
In that case, it makes sense that central banks would set the bond rate to be below the nominal return on capital, because they want to encourage borrowing at the bond rate and purchasing capital. They want to encourage investment, and they also want to maintain a positive inflation target.
All of that points to some form of long run equity premium apart from risk preferences.
Frances: your basic argument, as I understand it, is that bonds ought to have the same expected return as equities because it is possible to hold large portfolios of either, thus diversifying risk. But it is only the idiosyncratic risk of a security that can be diversified away; systemic risk cannot be eliminated by diversification. The systemic risk of equities is much higher than that of bonds. When you buy a large diversified basket of equities you are investing in the future real economic output of the sector or economy to which your basket belongs. A small change in your estimate of the future growth of this output has a large change in your estimate of the value of the basket. When you buy a large diversified basket of bonds, you are investing in a portfolio of cashflows that are nominally fixed. Yes there is default risk, but the component of default risk that is systemic corresponds to the Armageddon scenario in which no market instrument pays off. Yes, there is interest rate risk, but the equity portfolio is subject to the same risk. Yes, there is inflation risk, but in the economies that successfully issue large amounts of nominal bonds that risk is perceived to be small.
The very nature of a bond – an asset with downside but no upside – tells you what the market perceives it to be: a safe asset. High-yield bond account for a small fraction of the bond market. Remember that until Milken came along, there was no such thing as on-issue junk, only “fallen angels.” The buyer of a bond is buying safety, and has to pay the price of the hedge – there’s no free lunch.
It is also worth mentioning that the idiosyncratic risk of equities is so much higher than that of bonds that it makes a practical difference in portfolios. An equity hedge fund can happily cap its leverage at 2:1, but you can’t make money in bond arbitrage without 10:1 or 20:1 leverage.
One last point: the riskier a bond is (considered as an individual security), the more it behaves like an equity.
If there’s an equity premium, the CPP investment board and any other investor with vast amounts to invest over a long time period should buy only stocks. Increasing demand for stocks.
Well, let’s turn that around. If there isn’t an equity premium, why on earth would the CPP invest in stocks? If the long-run expected return is the same, and bonds are less volatile than stocks, they (and everyone else) would be crazy to invest in stocks.
In practice, of course, the CPP does invest signficantly in equity investments (though often not in publicly traded stocks). As of last spring, 54% of its portfolio was in equity investments, while 30% was in fixed income assets (the balance is held as what they call “inflation sensitive assets”, i.e., real estate, infrastructure, inflation linked bonds).
Of course, you might expect to see the equity premium change over time as people’s subjective perceptions of risk change. In the 1950’s, I’d imagine that the generation of investors who were raised during the Great Depression had a healthy appreciation of the risk of equity investments relative to government bonds, so you’d expect the equity premium to be significant, in order to induce people to invest in equities.
Conversly, the generation of investors who may have taken a beating investing in debt in the late 1960s and 70’s, might understandably be skeptical of the security of debt investments, and be willing to accept a lower (or non-existant) equity premium in the 1980s or 90s. In light of the volatility of the market over the past 3 years, we might be entering another era of high equity premiums, as aging boomers scarred by the last crash and worried about their retirement savings switch to safer investments.
“You can’t diversify away risk. I can’t diversify away risk. But surely the CPP should be able to diversify away risk.”
No.
Just…..no.
I like you, Frances. And, as a friend, I think you really should think hard about reading an introductory textbook chapter on risk and diversification. There’s lots of good ones out there.
Perhaps you could blog again after that.
“If there’s an equity premium, the CPP investment board and any other investor with vast amounts to invest over a long time period should buy only stocks. Increasing demand for stocks.
Well, let’s turn that around. If there isn’t an equity premium, why on earth would the CPP invest in stocks? If the long-run expected return is the same, and bonds are less volatile than stocks, they (and everyone else) would be crazy to invest in stocks.”
Um….there may be a good reason to invest in stocks even if (a) stocks are riskier than bonds, and (b) the expecteed rate of return on stocks is lower than that on bonds. It is quite possible that adding stocks to a diversified portfolio of bonds lowers the risk further still. (This is typically a mid-term exam question when I teach basic finance.)
The example that I used to use in class was gold; terrible rate of return (I think I need a new example this year — maybe I should use yen) and very volatile returns. But many people argue that gold has a negative Beta; it does well when other assets do poorly (at least that seems to be holding up) and vice versa. That means adding some gold to an otherwise well-diversified portfolio can lower the overall risk.
Simon,
Fair point. Given that for the immediate future, the government doesn’t need to dip into the CPP IB, that’s probably why they hold bonds.
Simon –
Just to clarify – I wouldn’t predict there to be no equity premium. Just a much smaller one than is generally supposed to exist. A dx sized premium.
I don’t think that reading a basic finance textbook would help, because the issues I’m having here are not economic.
The first is philosophical: the problem of induction. As Bob Smith has pointed out, the crucial issue is whether or not the equity premium exists going forward. And knowing that an equity premium has existed in the past doesn’t prove that one will exist in the future. It’s like the inductivist turkey, who wakes up happy and well fed on Christmas Eve and figures “I didn’t get killed yesterday, I should be just fine today.”
The second is psychological. Based on the blog survey we did a while ago, the people who read this blog are overwhelmingly male and highly educated. I.e. precisely the demographic that financial literacy research suggests are highly confident of their ability to invest in the stock market. I’m just way less confident, I’m the type of person who says “You can give me a bond that will pay me a return if the market goes up, but will still protect my premium. Great!” (Actually that’s not far off.) So I just don’t believe that I’m going to be that lucky, that my stocks are going to fly like an eagle, carrying me to some kind of Freedom 55 paradise.
Tell you what, if you’re right and my stocks do outperform my bonds by 50% over the next 25 years (or whatever you figure is a reasonable bet), I’ll buy you a $100 bottle of wine. 2011 $. Because I like you, too. And if the market does that well, I’ll be able to afford it.
But I’m guessing that by 2027, when the last of the boomers hits 65, the CPP starts winding down that big pension fund to pay for my retirement, every one of the boomers has switched from stocks to bonds to avoid that systematic risk, and there’s very few people in the peak investing years (50 to 65) we’ll see a huge sell-off in the market. Indeed we’re already seeing the early boomers hitting the age when standard investment advice says sell stocks buy bonds, but that should be offset by late boomers coming into their peak savings years.
Some of the more productive enterprises are funded by shares, not bonds, because the expected cash flows are uncertain, the inherent nature of innovation. So it’s not surprising that the vast majority of bonds cannot and do not play in this arena. It makes sense that those who invest in economically productive innovation should reap the spoils, but only if it’s truly innovative, and thus get a premium for their trouble. It has turned out enterprise is generally innovative and I expect this to continue. This often gets confused with volatility which involves a whole lot of non-innovative activities but once we filter that out it shouldn’t be surprising at all that equities have a premium.
I think the answer is that it isn’t an equity premium. It’s just a risk premium and it’s just that most equity is more risky than most debt. So the common stock of a particular company would outperform its bond. However, there is no reason why junk bonds would not perform similarly to some stocks. As for diversification, it works for both debt and equity similarly. So while you can use diversification to reduce your equity risk to the level of buying a single bond, you can also reduce your debt risk by diversifying your bond portfolio too. So the argument you are making for stocks would apply to bonds too, part of their risk premium gets competed away through diversification. Now we are back to a world where the higher risk in equity is rewarded with a premium.
there is an equity premium and it is 3.25738492835983274%.
The volatility of the equity market portfolio is between 12-25% (obviously varying with time). The volatility of the bond market portfolio is between 4-6% (again varying). This has been observed for a long time. If there was no premium from holding stock, the market would be irrational.
As said above you can see equity as a (usually deep in the money) call option on the same underlying asset (the whole economy, obviuosly not perfect, but a reasonable approximation). That gives you leverage (as the value of the equity is just the premium of the option which is much smaller than the value of the underlying asset), which gives you excess return (and the possibility of losing everything)…
Considering that average levarge is about 200% (ratio of company asset to market cap), a doubling of the return is not unreasonable (should be less since you would need to remove the time value of the option).
If you refuse induction, you refuse the scientific method… It’s like saying just because apples fall to the ground every day in the past it doesn’t mean they will fall in the future… Literally true, but not very helpful in trying to understand the world…
Actually scratch my leverage comment, that’s wrong. The time value should cancel that if we were risk-neutral… But people are not risk neutral so there is still an excess return…
Frances; Thanks for the offer of the wine; that’s very sporting of you. (I like a nice bottle of Spatlese.)
But I think you do have a problem with the economics; I think you would find it useful to work through the mathematics of diversification — particularly the difference between market and idiosyncratic risk. Understanding the idea of a stock’s “beta” might give you a different perspective. Not that it rules out time-varying risk premia…..
Frances: A few more comments on your post from 6:47 pm.
Induction: I have no problem with your reluctance to embrace induction. But your theories still need to be able to fit the facts. Your comments about historical stock and bond returns show that you could be more familiar with those facts. (Again, introductory finance textbooks cover this stuff.)
Psychology: I’m not sure that I understand your point here. I don’t invest with confidence either and I’m skeptical of the “Freedom 55” marketing that retail institutions bombard us with. So? What does that have to do with the equity premium?
Demographics: Yup, aging will tend to make retail investors switch from stocks to bonds. But lots of other factors may make those changes seem small. I’ve already mentioned the elasticity of supply argument. Remember also that financial sector can sometimes be pretty good at repackaging risk; most boomers would be happy to buy a pension from pension funds that invest in stocks and other assets. We’ve also seen big changes in retail investor tastes; stock ownership is much more widespread than it used to be (often through mutual funds or ETFs.) As a non-confident investor, how sure are you that the demographic effect will dominate?
Economics: Most finance professionals associate relatively high stock prices (relative to earnings or dividends) with low expected returns and vice versa. I think you’re arguing for low stock prices. Why don’t you think that means high expected returns? Given our low interest rates, doesn’t that imply a high rather than a low equity premium?
I promise I’ll let you have the last word.
Here’s another way to think about it — rather than from the buyer’s perspective, think about it from the perspective of the seller (one who needs finance). Let’s start as if there were no equity risk premium — the price of equity and the price of debt risk are equal.
If you view your business as a call option struck at zero (where the premium is the npv of all the startup plus ongoing costs), would you rather finance some of your business by giving away potentially unlimited upside or repaying a known, fixed stream?
Even absent tax benefits of debt, it seems reasonably intuitive that sellers of equity/debt return (i.e.,business owners) would prefer selling debt to equity at the same price (of risk) and keeping the unlimited upside for themselves.
Another interesting question is to then think about what the equity risk premium should be for short option / debt-like companies (e.g., banking and insurance — those businesses received mostly fixed, limited upside payments and have event risk that can take their enterprise value to zero very quickly).
intellectual hattips to Ian Ayres for “flipping it” and Nassim Taleb for “banks/insurance are short options”.
err, to finish the previous thought — marginal sellers of “debt return” –> lower price of “debt return” –> higher price of “equity return”
With 10-year TIPS yielding precisely zero, I sure as hell hope there’s still an equity premium!
Of course there is (ex ante, right now). The S&P 500 is selling at about 20 times average real earnings for the past 10 years. Make the ridiculously conservative (relative to conventional forecasts) assumption that average real earnings on the S&P 500 will be the same in the future as they have been over the past 10 years. Given this assumption, and with bonds yielding zero in real terms, you would need really bizarre assumptions to get an equity premium anywhere near zero going forward.
Will the equity premium go to near zero eventually? I doubt it, though I think the trend may continue to be downward. But unless you make bizarre assumptions about earnings, a near-zero eventual equity premium implies that the equity premium today is huge, because you will need huge capital gains (relative to bonds) to get prices to the level where they are consistent with a zero equity premium going forward.
Equities outperform bonds 3 out of 4 calendar years. Therefore, the risky portion of your portfolio should always be 3:1 equities/bonds.
However, your portfolio should be divided into a risky and risk-free portion. Risk-free means something where the principal is guaranteed by a CDIC-insured entity.
How much goes into risky and risk-free depends on your risk tolerance, age, funding needs etc. But the 3:1 ratio of the risky portion should be constant, no matter what.
(Source: “Investments”, Bodie, Kane, & Marcus)
“Equities outperform bonds 3 out of 4 calendar years. Therefore, the risky portion of your portfolio should always be 3:1 equities/bonds.”
Sounds like a pseudo-analytical rule of thumb.
Whether you’ll see an equity premium if you buy stocks today is, of course, unknown. But you should. Despite what you’ve written there is a higher risk to equity investing, and that risk should be compensated by higher expected returns.
Return of principle, plus interest, is a right for bondholders. The only way they’re not getting exactly what they expect is if the underlying company or government goes bankrupt and defaults. The risk of bankruptcy is quite low, practically non-existent for many bond issuers. Even if they do go bankrupt, the bondholder will still likely walk away with something, as they have a more senior position.
Equities generate their return through dividends and capital gains. These are entirely contingent on a company’s performance. While the risk of bankruptcy is low, the risk of underperformance is significant.
The same is true aggregated accross the entire market. If the overall economy underperforms, only a small number of companies will default on their debt, while the vast majority of companies will underperform. Bonds remain safer than equities, and therefore should generate a lower expected return.
Any world where there isn’t an equity premium is a world where equities are overpriced.
In the literature it’s called the equity premium “puzzle” for a reason. Brad DeLong and Konstantin Magin in a 2009 Journal of Economic Perspectives survey piece argue “degree of risk aversion needed to support the existing equity return premium seems extremely high.”
In other words, all these arguments about risk – the ones that I’m guessing are in the intro finance textbook Simon would like me to read – explain a small equity premium, but not an equity premium of the size that has existed historically.
Perhaps it would clarify things by stating the equity premium hypothesis in various ways.
1. The expected return on equities is just enough higher than the expected return on bonds to compensate shareholders for risk. Actual returns may vary. I don’t have any problems with that hypothesis, but given the long investment horizons and degree of diversification that can be achieved by large investment funds, the concentration of wealth in the hands of extremely rich people who can afford to take risks and also have long investment horizons, and the emergence of modern financial products, it seems that this would imply an equity premium smaller than, say, the 4%+ postulated by DeLong and Magin. Perhaps if I read Simon’s intro finance textbook I could figure out exactly what the premium would be.
#1 seems to imply that the equity premium continues, but is smaller than the historical one.
2. The expected return on equities is more than is required to compensate shareholders for risk, because market imperfections prevent the average investor from buying a fully diversified portfolio. Financial advisers give poor advice, take large overheads, corporate governance is flawed (see Mike’s recent post on this), people exhibit loss aversion and other irrationalities, etc. In this story, yes, there might be a large equity premium, but it doesn’t do the average investor any good, because they’re paying 2.5% mutual fund fees plus money to a financial adviser plus not minimizing their tax bill plus taking money out of the market at precisely the wrong time.
I’d believe that story too.
3. By buying the market through an exchange traded fund, it is always possible to beat the return on government bonds over time period X. That’s the version of it that I have problems with. If it was true, everyone would buy ETFs until the equity premium disappeared.
Tyronen: “Equities outperform bonds 3 out of 4 calendar years. Therefore, the risky portion of your portfolio should always be 3:1 equities/bonds.”
I’m with Andrew F on this one.
Simon, on the psychology/confidence thing, this G&M piece gives an overview of the literature, with links to some fairly respectable papers. (I don’t choose the title).
http://www.theglobeandmail.com/report-on-business/economy/economy-lab/frances-woolley/men-money-smart-or-just-more-confident/article2053726/.
Maybe loss aversion plays a role here. People hate losing $1 more than they like making $1. This might explain why people prefer the lower volatility and risk of bonds, beyond what the risk premium would suggest is reasonable.
I think your deduction in the last paragraph (which is standard in the literature) is incorrect, or at least premature/incomplete. There is another possibility. Just because present empirical results imply an implausibly high degree of risk aversion to explain movements in the equity premium, it does not mean the premium is not related to risk. It could simply mean that the risk models being used are not correct, or at least inadequate (attempting to connect the premium/risk to standard notions based on volatility, such as the CAPM and Value at Risk models).
Some recent work suggests a connection between the premium over bonds and P/E or P/D ratios (and other measures of price swings relative to a fundamental benchmark). As expected returns over bonds increase (due to expectations of earnings/dividend growth), prices rise until the price relative to some benchmark (E or D) is high enough to offset the excess return. This is a notion of risk which relates to the possibility of a reversal, or downside risk, which would be potentially sharper for a given small move in earnings the further the P/E ratio. These swings in prices relative to benchmarks represent an alternative notion of risk which links it to price swings (rather than price volatility) and seemingly can well explain the premium. When expected earnings growth becomes less optimistic, P/E ratios fall, the “downside risk” falls, and the premium of stocks over bonds becomes lower, or even non-existent. This GAP between the P/E ratio and its “benchmark” long run levels provides the offsetting risk to compensate for differences in returns.
The same model has been applied to the foreign exchange market to explain the premium puzzle there, relating the premium to the GAP between the exchange rate and its Purchasing Power Parity Level (a fundamental historical benchmark similar to P/E or P/D ratios). Frydman and Goldberg (2007) and there after have found (in my opinion) convincing empirical support for such a model of the premium.