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 
A “physicist question”: Understanding that I am speaking in averages over many investments and this may not be true in specific cases, what is wrong with this argument?
With some extra cash I wish to invest I have a choice: lend money to a company (ie buy bonds) or invest in the company (buy stock). Presumably the company would expect to borrow the money (sell me a bond), invest the money, produce more, make money, pay me back and still make a profit.
If I put $1000 into a corporate bond I get the interest back. If I invest $1000 in a company I get the “interest” plus the profit. Hence an equity premium.
Chris J – “If I invest $1000 in a company I get the “interest” plus the profit. Hence an equity premium.”
Not quite, unless I’ve misunderstood your argument.
The problem with that reasoning is that there is no reason why would the company ever allow you to invest in stock. Any company that’s reasonably confident of being able to pay the interest will do so.
So a company that issues stock has a non-trivial possibility of not being able to pay the interest back.
Which suggests that there should be an equity premium to compensate you for taking on that risk. The only question is: is that premium small or large?
An exchange traded fund can buy shares of every company in the market. Some will go up and some will go down but, on average, the expected return should be fairly stable – the idiosyncratic risk should get washed away. Market risk – the economy and the market going up and down – should also wash out over time. This is why I’ve been arguing that the equity premium will, going forward, be smaller than it has been in the past.
Would be happy to be wrong, of course.
It is not necessarily….: That’s an interesting comment.
@Frances, something to consider is that even in the “equity” and “bond” camps there is diversity, namely that there are various schemes of bonds that deviate from the normal vanilla variety, that put them more into the equity camp. Likewise preferred shares and the like start encroaching more on bond-like behaviour. My point here is that there is more a continuum of equity and bond investments than two discrete entities, and comparing them as classes is difficult. By looking at returns on smaller tranches of bonds and equities you might be able to resolve a slope on a return graph that will point to what’s actually going on.
I agree with some of the above sentiment. Put yourself in COO shoes and figure out why s/he would choose issuing more common stock instead of a bond.
Stock returns are correlated. You can have a huge basket of stocks that doesnt make it risk free as we just saw a few years ago or this week. Stocks are more volatile than bonds.
Second, lets assume independence as you do. Further let’s assume that the number of indepent stocks is finite and the number of a independen bonds is of similar number. Individually stocks have more risk. You suggest that the aggregate risk equalizes. Certainly not, it takes many more uncorrelated stocks to equalize the risk. That’s just on your terms of debate.
Now I go back to my claim that the ‘basis set’ of stocks is actually quite small.
It’s was precisely the neglect of correlated risk that led to the massive MBS loses. Structured finance can only reduce uncorrelated risks!
Frances, I think one crucially important point is that returns on equities may be greater over extended periods of time, but they can be a great deal smaller than bond returns over very individually significant periods of time (eg the last decade.) A prudent individual investor does not want to risk being exposed to large equity losses immediately before and after retirement and hence is wise to have a mixed portfolio nothwithstanding any putative difference in very long run returns.
I’m not even sure about an equity premium at all. I would have made out like a bandit if I had purchased long Canada government bonds back in the late 1980s/early 90s before the Bank of Canada went on their anti inflation crusade.
“The problem with that reasoning is that there is no reason why would the company ever allow you to invest in stock. Any company that’s reasonably confident of being able to pay the interest will do so.”
Ah, but no lender will lend money to a company with no equity (at least not at any reasonable interest rate – try getting a shell company a loan without guarantees from its shareholders). So to be able to borrow, the company has to have some initial level of stock. Once it’s out there, there’s nothing a public company can do to keep me from investing in it. However, we do observe the behaviour you describe in other forms. For example, companies buying back shares rather than repaying debt (or even borrowing money to buy back shares). It’s also the logic of the debt-financed cash take-over bids of the last decade. Of course, just because that’s the logic, doesn’t mean that the people doing it are right (although I’d like to think that people playing with billions of dollars aren’t completely out to lunch).
Is information insensitivity a factor here? Most high rated bonds are dominated by the single variable of interest rates. Not so for blue chip equities. ETFs have helped equities here though.
An asset with higher information insensitivity should command a higher price due to being more liquid. Long run returns don’t matter one iota if the market is not forward looking enough, which in general it isn’t, because if it was it would have priced
Dang. A post I can actually make substantive comments on, but posted when I’m on vacation. I’ll get back to this in a week.
Almost every bond default by a publicly held company leads to bankruptcy. In bankruptcy, equities and subordinated bonds are almost always wiped out, while bond debts to general creditors generally received double digit percentage repayments. Moreover, there are many companies that never default on bonds that still have almost all of their equity wiped out in the face of poor performance by the entity.
Leverage and subordination makes stocks inherently more prone to downside risk and more volatile than ordinary corporate bonds. At the very least, an apples to apples comparison requires that one compare equity to subordinated bonds.
One important reason that this risk can’t simply be eliminated with a diversified portfolio is that equity value losses and bond defaults in different firms are not independent of each other. Companies don’t default on bonds and have their equity wiped out one at a time. Instead, during booms all equities generate positive returns and no bonds default, while in recessions the entire market capitalization of equities falls in value (disproportionately relative to firm level profits and revenues because they are leveraged) and all of the bond defaults that are going to happen tend to happen at once. Increasingly, these correlations extend even across national boundaries. But for the California housing bust, Iceland might not have defaulted on its national debt.
To the extent that changes in equity value and bond default rates are not independent, the risk involved in a diversified portfolio is the same as the risk of investment in a single firm, equities are riskier than debt, and the equity premium is justified. For example, when the investment banks collapsed in the financial crisis, Fannie and Freddie tanked, AIG came into government ownership and two of the three American automobile manufacturers in the United States went bankrupt, equity owners and subordinated bondholders were wiped out pretty much across the board, but general unsecured bond creditors were almost entirely unscathed.
Put another way, it is mathematically legitimate to decompose risk into firm specific risk and marketwide systemic risk (or if you prefer a more complex model, firm specific, industry specific, and marketwide risk). To the extent that there is any marketwide systemic risk in that decomposition, you can’t escape it with portfolio diversification. And, if the average investor by value is risk averse (something that is empirically true) then investors will willingly trade the ability to avoid a downside risk for more than the expected value of the downside risk avoided.
There are legitimate reasons for some investors to be risk averse. One reason to invest is to save for anticipated future expenses, like college tuition or retirement. This purpose restricts the ability of an investor to engage in market timing. A typical investor’s objective is not to, “maximize my rate of return”, but to be able to answer the question: “how much do I need to save to be confident that I have $X in 2016.” An investor with the latter objective should be more concerned about downside risk than the potential for upside gain that equities have and bonds do not have to the same extent.
Moreover, many of the risks faced by bondholders (e.g. interest rate changes) are marketwide risks that cannot be escaped by diversification, and are risks that are faced by equityholders as well as bondholders, in addition to the risks which are unique to equities.
Tax motives are a worthwhile consideration as well. U.S. taxpayers have historically paid lower effective tax rates on gains from equities than on gains from bonds, have more control over tax timing, and can sometimes defer paying taxes forever due to the step up in basis of capital gains at death. I would not be surprised if a significant share of the preference for equities over debt attributed to an excessive risk premium is, in fact, a form of taxation premium (similar to that seen between municipal and corporate bonds). One way to measure this would be to compare rates of returns for subordinated bonds (which have similar risk of downside loss to equities empirically but very different tax treatment) to the rates of return on equity investments in the same companies.
@Frances – thank you.
ohwilleke,
Differential tax treatment may explain a demand side preference for equity over debt, but the preferential tax treatment for issuer of debt over bonds (other, obviously, than governments), provides an offsetting supply side preference (since interest on debt is generally tax deductible, while dividends are not – at least in the US and Canada, some jurisdictions do allow the deduction of dividends). Investors may well prefer equity income, but issuers don’t. It’s hard to tell whether one preference would dominate the other, but I would suggest that since a significant chunk of the world’s investors are not entitled to the preferred tax treatment of equity (i.e., non-taxable entities such as pension plans, and non-residents, whose home countries, like Canada do not generally provide shareholder level recognition for foreign corporate-level tax (at least in respect of portfolio holdings)), the supply side would dominate.
Indeed, what this suggests is that, in the absence of an equity premium, the pre-tax return on equity should be considerably less than the return on corporate debt, since equity income is taxed less heavily than debt income at the investor level (and therefore investors would be willing to accept a lower return on capital in the form of income from equity) and since interest, but not dividends, are deductible (and therefore issuers are willing to pay interest at a higher rate than dividends). Somehow, I doubt anyone will observe that phenomenon for any reasonably lengthy time period.
Andrew Jackson: “long Canada government bonds back in the late 1980s/early 90s”
If every other form of tax increase is off the table, the US will have to levy an inflation tax to finance their debt. In the short term that would reduce interest rates, but once inflation was well-established, we’d see nominal rates rising to compensate for inflation risk.
That would impact the equity premium.
(It’s sweetly ironic, isn’t it, that the 1980s/early 1990s “bad” CPP investment policy – lending funds to the provinces at very long-term fixed interest rates – has provided great returns relative to some of the more recent “good” CPP investment policies?)
The suggestions that Frances “read an introductory finance textbook” and the specific reference to Bodie, Kane, and Marcus (one of the most widely used finance textbooks) are a bit ironic in view of the fact that Zvi Bodie, the senior author of that textbook, advises a course very much like the one Frances advocates above in his investment advice book aimed at the general public:
See here:
http://money.cnn.com/2009/09/16/retirement/Bodie_stock_allocation.moneymag/
See also his book http://www.zvibodie.com/Worry_Free_Investing, which is endorsed by two economists who have won Nobel honors for their work in finance.
To go back to the original questions which interest me rather a lot since I am a middle aged boomer who will depend on my investments to fund my retirement:
1) It seems likely that part of the historical equity premium reflected transitional effects. In the long run the stock market cannot grow faster than the (world) economy.
2) There can still be a small persistent equity premium to reward those willing to tolerate volatility but timing issues and survivorship bias make the calculation of that premium very difficult. On the other hand bond holders have to be compensated for inflation risk which might outweigh the volatility risk of shares.
3) Most investment advice seems to be based on time horizons that are too short. A middle class Canadian who starts saving at 30 should have an ultimate planning horizon that includes the possibility that they (or their spouse) might live to age 90. Given the risks that inflation pose for bond investors, it seems prudent to have significant portions of your holdings in diversified equities until you are into your 70s at least.
This thread has done a good job examining the Securities View of stocks vs. bonds; one which takes the viewpoint of an outside investor and considers each to be independent and posits a choice between them.
But there is a fundamental flaw in this view: stocks and bonds are not independent. It’s all in the balance sheet.
Firms possess equity, the net capital owned by shareholders. Firms borrow money to invest and earn a return and expect that the return on their investment minus the interest and principal on the borrowed funds will be positive. This is straightforward management.
That return is credited to the shareholder’s equity. Since equity is a small amount compared to assets, the return on equity is higher than the return on assets. This basic leverage.
The end result is that the return on equity is higher than the return on assets and higher than the return on debt by balance sheet structure.
The most controversial point I will make is my next one. In the limit, the value of a stock will trend to the value of its current equity plus its net present value of future returns. The discount rate is the return on equity, which I previously established to be higher than the expected return on debt instruments. So the expected return from holding a stock is the return on equity. By the structure of the corporate balance sheet, it is higher than the return on borrowed funds corporate borrowing would be irrational.
This is the the “Inside” or Business Ownership view of stockholding rather than the Securities or “Outside” view of stockholding.
Determinant
You have a typing error in your penultimate sentence.
I agree that expected returns on equity are higher than expected borrowing costs but it is not true to say that returns on equity must in the result be higher than borrowing costs. One of the wild cards in all of this is the fact that interest and equity returns are taxed differently. To some extent the decision by a company to access debt or equity funding is driven by the existence of pools of different investors with different tax circumstances.
Possibly Joe. But the Dividend Tax Credit is designed to recognize the existence of Corporate Income Tax. DTC posits that as the owners of the company, the actual tax burden on a dividend is the combination of the corporate and personal income tax. The theory is that the ownership of funds during a distribution of dividends does not change and the DTC compensates for the CIT already paid since dividends are not deductible for tax purposes.
The net result is that dividend income tax rates must include the CIT already imposed to compare apples to apples. To ignore CIT completely and argue that this is a tax distortion is debatable and in my opinion fallacious.
Determinant,
I agree that the existance of the DTC eliminates the distortion caused by CIT, but it only does so for shareholders who can claim the DTC. But, of course, a good chunk of the shares of Canadian corporations are owned by persons who can’t claim a DTC (either non-taxables, such as RRSPs or Pension Plans, or non-residents).
This is why income trusts took such a beating when the government started taxing them as corporations and allowing unitholders to claim a dividend tax credit on certain distributions (I’m simplying greatly, the SIFT rules are a mess). If you were a Canadian resident taxable shareholder, you should have been generally indifferent (on an after-tax basis) between holding units in an income trust or a corporation (although there might be a cash-flow advantage to an income trust), but if you were a non-resident or a non-taxable, income trusts were infinitely superior on an after-tax basis, since those investors aren’t able to claim an ITC to offset entity level tax.
Moreover, the DTC doesn’t apply to income from foreign stocks. Although most Canadians have a strong home bias in investment, this will tend to discourage investment in foreign equity. Also, the DTC doesn’t provide recognition for entity level tax on retained earnings (although to some extent that is offset by the preferred tax treatment on capital gains).
RRSP’s and Pension Plans are engaged in the business investing deferred taxes. This is explicitly recognized in the literature. The fact that they pay a reduced rate at present is a tax expenditure and social policy tool, again both explicitly stated in government policy and in the literature.
I have in the past signed a T1213 form which allows you to claim a tax reduction at source against a monthly RRSP contribution. The CRA will happily allow you to defer your taxes with this form.
Second since foreign stocks have fully taxable dividends, just like fixed income interest payments, we are again back at square one. Of course stocks promise dividend growth so there is a simple reason for an equity premium.
Determinant,
But the problem with RRSPs and Pension Plans is that you NEVER get recognition of the corporate level tax, non-taxables can’t claim a DTC, and the income that they distribute to heir holders/beneficiaries is not eligible to claim DTCs. You may well pay tax at a lower rate when you withdraw money, but that’s a function of having a lower income, not a recognition of corporate level tax (i.e., interest income earned by an RRSP or pension plan gets taxed at the same low rate.
In any event, I’m not arguing that there isn’t an equity premium, in the absence of taxes of course there is, I’m arguing that the effect of the tax system might tend to offset it by creating a willingness for issuer to pay higher (pre-tax) returns on debt than equity, and conversely a willingness on some investors to accept lower pre-tax returns on equity than debt.
Read Eric Falkenstein. I think he puts together a pretty good case that the equity premium is an illusion.