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Equity Risk Premium

By: Frank Armstrong

*As seen on Forbes

You have one dollar to invest, but you are about to leave on a very long trip. You will be totally out of touch. No iPhone, radio, newspapers, email or even letters (remember them?). No news will reach you. No messages can come back from you. You won’t be able to see how you are doing or change your mind until you get back a long time into the future. Should you play it safe, or take a prudent amount of risk? Buy Treasury Bills or the US Stock Market?

As you ponder your choices back in 1926 you have no clue that you are on the cusp of a cataclysmic stock market crash followed shortly by a catastrophic global depression, that you were leading up to a World War that will take over 50 million lives, a number of other financial panics or the attack on the US on 911. You can’t imagine a computer, atomic bomb, microwave, supersonic jet strategic bombers, or the internet. You couldn’t have predicted that any of these things would happen, let alone the timing. For both good and evil the world will change in ways you cannot begin to fathom, and the pace of that change will accelerate.

You can’t know it at the time but when you return at the end of 2104 one choice leads to $21 and the other to $5313.

You do know that like most other people you don’t like risk in your investment portfolio. Volatility is disconcerting. Certainty trumps uncertainty. Or does it? Clipping coupons in a safe portfolio sounds attractive. However, the prospects of a higher return are tempting. What to do?

Risk is the central question facing investors. If they want a return above the zero risk assets, how much risk should they take and how much aggravation can they put up with? As previously discussed, returns on fixed income investments are unlikely to provide the real return necessary for investors to reach any reasonable goals. Like it or not, they may have to accept some amount of equity risk. Fortunately we have a wealth of data about the various dimensions of equity risk and their impact on expected returns.

Investors demand that in return for bearing an equity risk they should anticipate a premium on their return. Essentially what investors are demanding is a risk free rate of return plus an additional premium for taking risk. Prices adjust until they get it. This works out remarkably well on an asset class level where prices are driven down until looking forward investors can achieve their desired return for the risks involved. It’s an almost magic process where prices almost instantly respond to perceived risks and investor’s need for future profits.

Note that this process only works in a diversified portfolio. Buy one stock and you accept a boat load of uncompensated risk. You shouldn’t expect any additional return for accepting this or any other uncompensated risk. That’s why it’s called uncompensated. Uncompensated risk can and should be diversified away. But, at the end of the diversification process you are still accepting market risk. Every equity investor bears market risk. That’s never going away. You are in the market, or you are not.

By the way, market risk and the associated return are often referred to as Beta by the pointy heads. But, let’s keep this simple.

So, what’s the premium for market risk? That’s easy. Just take the total return of the equity portfolio and subtract the risk free rate. From 1926 to 2014 the S&P 500 had a compound return of 10.5% and the 30 day Treasury bill compounded at 5.1%. So over that time the compounded equity risk premium was 5.4%. (A pure average would have been higher, in the neighborhood of 8.1%)

It would certainly be nice if these risk premiums showed up every year. Dream on! That’s where the risk part comes in. On a year by year basis, sometimes they are there, sometimes not. Worse yet, sometimes they are negative – a lot! And sometimes they stay that way for a while. But, you are systematically rewarded for putting up with this uncertainty over longer periods. And if you can keep your wits about you through thick and thin the reward is generous.

As we look at the chart we see very few average years, lots of losses, but far more gains. On average we win more often than we lose, and cumulatively the rewards are generous.

Here’s another look at the distribution of returns: Notice you won 75% of the time.

But, in order to capture the additional expected returns we must be patient, sometimes for an uncomfortably long period. For instance, from 1965 to 1981 there was no premium, prompting the famous “Death of Equities” cover story on Business Week. That cover preceded the greatest bull market ever by just a few months. The lessons here are that you must keep the faith and that during the inevitable dry spells your own behavior may be the biggest risk you face.

Market risk isn’t the only risk investors need to sort out. However it’s the prime driver of investment results. But, it turns out that there are several other factors that generate their own set of risk and return tradeoffs. More about those factors later.

In spite of the variability of returns (risk) the stock market is a winner’s game and perhaps the greatest generator of wealth the world has ever seen.

Hopefully you made the right choice back in 1926, captured all those juicy risk premiums, and are enjoying the fruits of your good decision today.

Disclaimers:

All the standard disclaimers apply: No specific investment advice is implied. Tomorrow will not be like the past, and past returns are certainly no guarantee of future returns.