Download The Equity Risk Premium

The Equity Risk Premium
So that there is no suspense, here is the bottom line:
The future will not be as bright as the past.
Bradford Cornell, The Equity Risk Premium:
The Long-Run Future of the Stock Market, 1999, p. 201.
Despite magazine covers that proclaim at the supermarket “10 Safe Stocks for the Next Decade;” stocks
are risky. To take risk is to expose oneself to a meaningful chance of injury or loss; stock investments (i.e.,
equities) harbor hazards and perils that could jeopardize one’s wealth. Speculators, of course, by definition
are ready to ante up for a shot at spectacular wealth, but all speculators taken together are but a shallow
well from which to draw the capital needed by the equity market. Rational, prudent investors are required,
and prudent investors require from the market a return substantially greater than what one would expect to
earn in risk-free investments. If one expects to earn 5.0 percent, say, by investing in short-term T-Bills—a
fairly riskless investment—the prudent investor would require a return higher than 5.0 percent to put his
capital at risk. This extra return, that is, the difference between what a prudent investor expects to earn on
T-Bills and expects to earn on the stock market, is called a premium. It is a bonus or inducement for
prudent investors to risk capital in equities. This premium is called the equity risk premium. Sometimes it
refers to the premium over long-term Treasury bonds, and sometimes the premium over T-bills. Here,
equity risk premium means the premium over T-bills.
How much is the equity risk premium? In terms of long-term data, we have reliable return data on the
U.S. stock market as found in the Standard & Poor’s 500 Index, and we also have return data on 30-day Tbills: both data sets run from 1926 to the present. Using these indexes, the equity risk premium from 1926
to 1998 is 9.25 percent. That doesn’t mean that the prudent investor believes an investment in the stock
market returns 9.25 percent over T-bills each and every year, rain or shine. Indeed, it is quite clear that
some years will return a great deal more, and some years will witness substantial losses. Such fluctuations
are called volatility risk, and volatility risk is high in the equity market. But the prudent investor accepts
volatility risk as part of the investment process. The reasonable expectation is that over the long run the
equity risk premium will average an amount large enough to justify the investment in stocks.
What does “long run” mean? Suppose we assume that 20 years will serve as an adequate proxy for
“long-term investment.” From January 1926 through December 1998 there are 636 20-year periods
beginning on the first day of each month starting with January 1926. If we calculate the premium for all
those 20-year periods, the average equity risk premium of those 636 sets of returns is 6.72 percent. Half the
time, from the 25th to 75th percentile, the average 20-year returns ranged from 3.04 percent to 10.93
percent. The worst period was from April 1962 to March 1982 (long after the great crash of 1929!); for that
20-year period, the annual equity risk premium was a mere 0.23 percent.
So what’s the premium going to be for the next 20 years? If we take the historical average and make
the appropriate adjustments for volatility (as volatility reduces the total return), we would expect an equity
risk premium of 7.2 percent, which if we add a 5 percent T-bill rate (about what it is today), then we would
expect to have an average total return of 12 percent or so.
One can’t help but observe that a 12 percent return is much lower than what many 401(k) participants
expect to make in the stock market; their expectations are sharply influenced by the performance of big
technology stocks over the past three years. Yet, among those who seriously ponder the equity risk
premium, no one argues for an equity risk premium greater than the historical equity risk premium. Most
scholars believe that the equity risk premium for today’s investments is much lower than the historical
returns would suggest.
There are three main lines of argument. The oldest argument has many variants, but they all follow a
pattern. Instead of using historical estimates of the equity risk premium, they all use forward-looking
estimates that derive in one way or another from economic theory. One example of this is a theory
proposed by Jeremy Siegel who argued that earnings yield, defined as earnings per share divided by share
price (the inverse of the price/earnings ratio) is the key determinant of long-run real returns on common
stock. The historical data does not contradict this, as the compounded real return from 1926 to 1997 was
7.7 percent, and the median earnings yield over the comparable period was 7.2 percent. This argument
derives from basic economic theory, which says earnings, whether paid out as dividends or retained for
investment, are the ultimate source of value for shareholders. In 1998, the earnings yield on the S&P 500
fell below 4 percent for the first time in postwar history. Under Siegel’s argument, this would mean that the
equity risk premium should be about 3.7 percent less than the historical average (see Chapter 5 in his book
Stocks for the Long Run, 2nd ed.).
The second argument was developed by William Goetzmann and Phil Jorion, (“Global Stock Markets
in the Twentieth Century,” Journal of Finance, June 1999), and it revolves around the phenomenon called
“survivorship bias.” A simple illustration might help. Suppose we invest $250 in each of four stocks. The
first stock earns 50 percent, the second stock earns 20 percent, the third stock earns 10 percent, and the
fourth stock goes bankrupt mid-year. We end the year with $950 ($375 + $300 + $275 + $0), or a loss of 5
percent on our $1,000 investment. Survivorship bias occurs when one calculates the returns on this group of investments using only
the survivors at the end of the year, which in this case are the first three stocks. The survivors returned over 26 percent, much more
impressive than a five percent loss. Survivorship bias is a virus that can infect indexes and the composition of mutual fund peer
groups, but not just that.
Goetzmann and Jorion argue that it affects our historical estimates of the equity risk premium. In fact,
they argue, it infects the historical estimates of the equity risk premium with a deadly vengeance. Not only
do we only look at today’s market survivors (many stock markets have completely collapsed in this
century), but we also pick only one country. And not just any country, but the one that turned out to have
the best economy of the 20th Century—an outcome that was by no means evident in 1899. The U.S. not
only had the best economy, but during that century there was no hyperinflation, no wars fought at home, no
market interruptions, and the U.S. had many other strokes of good fortune that no other country enjoyed.
As a result of this, Goetzmann and Jorion argue that the U.S. is not representative of equities in general,
and is unlikely to be representative of the U.S. market in the future. They estimate that survivorship bias
overstates the equity risk premium by 4.0 percent, which, interestingly, is close to Siegel’s estimate. To
gauge the impact of a 4.0 percent reduction, consider the S&P 500. With an average annual return of 11.2
percent from 1926 to 1998, a $1.00 investment would have grown to $2,147. A reduction to a return of 7.2
percent means that $1 would have only grown to $163, or less than 1/14th of the historical amount.
The third line of argument is that the risk premium is permanently declining. In the March 30, 1998
Wall Street Journal, James Glassman and Kevin Hassett argued that today’s high level of stock prices is a
result of a permanent drop in the equity risk premium. While there are many different reasons why this
might be so, there are two principal arguments. The first is that stock market risk has been permanently
reduced. The biggest risk of investing in equities is insider trading and fraud. The development of securities
laws, the extensive regulation and monitoring of the equity markets, and the development of generally
accepted accounting principles have gone a long way in reducing the greatest risk of investing in the
markets. Second, it is argued that the development of modern financial theories, the careful historical
research of the last quarter century, and the growing impact of institutional investors of fiduciary accounts,
have altered the perception of the risk/reward trade-off in the investment community. Today, our
understanding of the risk/reward tradeoff has been permanently altered by the development of modern
portfolio theory, our growing knowledge of the capital markets, and our ability to analyze them and
evaluate risk and return.
One very interesting consequence of this last argument is that, if it were true, it would lead to a
permanent increase in stock prices. In fact, it would work much like the relationship between interest rates
and bonds. When interest rates fall, that is bad news for new bond investments, but great news for one’s
current bond holdings, for the drop in interest rates drives up the value of the bonds. It is similar with a
permanent drop in the equity risk premium. Let me illustrate this with a simple example that uses some
silly numbers and assumptions for expected returns, but makes the underlying math more transparent.
Suppose everyone required a return (i.e., the T-Bill rate + equity risk premium) of 100 percent, and, luckily
enough, I owned something that cost $100 and in a year would be worth $200. Suppose a fairy sprinkles
magic dust on investors, and after lunch everyone now only requires a 50 percent return. That evening I sell
what I owned for $133. What has happened? Nothing has changed about what I owned; the world is just the
same. What has happened is that other investors only require a 50 percent return, so they will happily pay
an extra $33 for something that will be worth $200 in a year (a 50 percent return on $133 is $67, for a total
of $200). Assuming that was the last of the magic dust, this phenomenon would never happen again. My
gain would be a one-time stroke of good luck, and the price of this thing would be permanently increased.
A decline in the equity risk premium works in the same way, although the applicable math that is used to
calculate the relationship between a permanent increase in the valuation of equities and a decline in the
equity risk premium is a bit more complicated. The calculation uses the constant growth version of the
fundamental valuation equation (for those who care). It tells us that a drop of five percent in the equity risk
premium would lead to a 167 percent increase in stock prices! If this were to happen, it would probably not
happen instantly, as implied in the example (after all, there is no magic dust), but over a number of years. If
it happened over five years, say, at 1 percent per year, it can be shown that just the declining premium
would cause an average annual return of over 40 percent.
Of course, if the equity risk premium were now declining, this would make the use of historical data
very dangerous indeed. First, before the recent bull market, the historical data would already provide an
estimate of the equity risk premium that would be too high. The recent bull market, under this theory,
would be quintessentially affected by a permanent reduction of the equity risk premium, so the run-up
would make the historical averages higher and all the more misleading!
The riddle of the equity risk premium has generated vast literature, most of it quite technical, and
littered with many other arguments and puzzles. Bradford Cornell’s Equity Risk Premium: The Long-Run
Future of the Stock Market provides an outstanding review and assessment of all that has been written on
this topic. But when all is said and done, it is no great surprise to discover that we just don’t know whether
or not the equity risk premium is lower for the future than for the past. Only in hindsight will we know for
sure. Yet the genuine possibility of an equity risk premium that is much lower today than in the past should
give plan sponsors pause for thought. When baby boomers startretiring, often with vast differences in their
401(k) accounts, and when some boomers find themselves shockingly needy, they will seek remedy in the
courts. And if it is like the plaintiff courts of today, jurors will make their judgments using hindsight, even
though the legal requirement is “under the circumstances then prevailing.”
In the 1990’s the trend was to persuade 401(k) participants out of money markets and GICs into
equities. The enormous rise in the stocks of some of the biggest and well-known companies has
supercharged those efforts with subtle (and not so subtle) appeals to greed. It has increased demands from a few but
growing number of vocal participants for riskier and riskier investment alternatives, and it has even affected investment committees.
But the well-known caveat that the past does not predict the future, becomes more than a caveat when one realizes that so many
reasonable arguments can be mustered to conclude that the equity rise premium is materially less than history suggests.
If the equity risk premium turns out to be substantially lower in the future than in the past, it will still
be sufficient for a prudent investor to invest in equities. But it will also make it even more imperative for
the prudent investor to diversify among the many different equity asset classes. Above all, plan sponsors would
be wise to temper any enthusiasm for equity investments. Those who sell mutual funds appeal to our greed, for getting a piece of
investors’ money is their business. But it may be wise for plan sponsors to temper such appeals when made to participants. Risk—
so hard to see in the bright sun of the unprecedented run-up in large-cap growth stocks—should be made at least as obvious as past
returns.
Descriptions of 401(k) plan investment alternatives influence expectations, directly and indirectly,
both today and in the piercing hindsight of tomorrow’s courtroom. And there is wisdom in Marie Antoinette’s
famous words, “Let them eat cake.” It is not those who cry for bread who make revolution, but those who have bread and want
cake. One wants an attractive 401(k) plan. But perhaps the counsel of wisdom is to resist the temptation to paint images of cake,
when bread is a more reasonable expectation, and when it may turn out there is not enough bread to meet expectation or even
need.