The Equity Risk Premium

Victor has been thinking about the long term risk premium, and has links to some other deep thinkers.

As a sometime deep-thought-thinker myself, let me toss out an argument about the US equity risk premium that I read a few years ago, and liked well enough to repeat from memory now [And this .pdf file may open for you - trust but verify].

The theme is that calculations of the US equity premium are affected by survivor bias.  If the US had collapsed into Communism during the Great Depression, or lost WWII, or been blown up during the Cuban missile crisis, or lost the Cold War, the conversation today would not be "What are stocks expected to return during the 21st century?".  Instead, folks would look at old newspaper clippings and wonder why any fool at all ever bought equities (C'mon you know that conversation - just flash back to your breakfast table circa 2001).

Relatedly, as of 1850 the US looked like an emerging market with a perilous amount of political risk.  Even in 1900, a prudent global investor would want a portion of the portfolio in more established economies.  Britain ruled the waves, both Germany and the Austro-Hungarian empire were available - how did investments in Vienna and Berlin work out, anyway?

The gist - looking backwards at US returns, after the bullets we dodged, probably overstates the risk/reward ratio going forward.  So, with that background, do you want me to give you a number for the appropriate US risk premium?  Fine, "lower".

If I could get this paper to load, I think I would see estimates of 3 to 4%.  OK, I'll guess 5% for my personal benchmark, but the 6.5% to 7% often tossed about strikes me as high.

P.S.  I have a Super Bowl story about James Carville I have had on the "to-do" list for about eighteen months (I missed last year).  I can't promise that if you bug me to post it the wait will be worth it, but it will clear my conscience (YES, I have one.  Weekends only).

Comments

[Regret]

I agree that the equity risk premium and the long-term expected return for the U.S. stock market should be assumed to be much lower than that which applied during the 1900s. This may turn out to be conservative assumption, but in this case making conservative assumptions is prudent.

However, I don't think that this should be a focus of the current discussion on private accounts in the Social Security system. Rather, we should push for structural changes that have some chance of passage in the current political climate and then try to make incremental improvements to the structure as we go.

As you point out, no one correctly predicted that the world would look as it does now even 50 years ago. So, we have to assume that we won't know what it will look like 50 years hence.

Giving people increasing amount of control over their own savings dollars gives individuals the best chance to adapt to changes in the world as they come, rather than waiting for belated (and reactionary) changes made by the Federal Government. If we can just get the door open, perhaps the investment flexibility in these private accounts can be improved over time, and the return of the U.S. stock market will not determine the success of failure of the system.

In the best case scenario (where individuals have very flexible investment options): if U.S. growth is stalling, hurting the U.S. stock market - individuals would be able to invest elsewhere. Conceivably, there could be investment choices which include exposure to alternative investments, like foreign stocks, hedge funds, commodities, futures, and private equity, which have the ability to generate returns that are not correlated to the U.S. stock market.

Sadly, I don’t think that politicians (especially on the Left) have enough confidence in an individual’s ability to make good decisions for themselves, so suggesting that Joe Six-Pack’s social security savings might end up in hedge funds would provide ammunition with which to shoot down the private account idea altogether. So, let’s start with something simple – let it putter along for a few years, and get the Great Ownership Society underway. Later we can add some bells and whistles.

[ben A]

So by investing in US equities I am essentially going long on American Exceptionalism? Suh-Weet!

[Paul Zrimsek]

On the other hand, if Krugman & Co. succeed in convincing everyone that the only safe place to park their money is the SS Trust Fund, won't the equity premium go up?

[Mike]

I have a Super Bowl story about James Carville . . .

Please, for the love of all that is holy, please, don't let it involve a "wardrobe malfunction."

[Buckaroo]

OK.

So, we had a bigger risk premium built into prices from 1850 till, now, but we turned out to actually have had the lowest risk anywhere on the plant.

Now, the risk premium built in to prices is the lowest on the planet. What do you suppose our actual risk is from here for the next 150 years?

I'd imagine that the actual risk going forward is probably similar to the actual risk other empires have experienced historically.

The question is: are we paying a risk premium on current equity prices based on the history of the past 150 years extrapolated forward?

Extrapolating forward could incorrectly discount real risks, if you've had a long stretch of outperforming the world and you're reached the peak of your power. Even if you stay at the peak of power indefinitely, you wouldn't be increasing your peak of powerness.

If you have destiny on your side, do you have ever increasing destiny on your side, or do you eventually reach a plateau that could cause mathematical problems extrapolating destiny forward and incorporating that into equity prices?

And what happens if you take it out a level. Does the world have destiny on its side? Where's real worldwide risk and what risk premium is built in?

[liberal]

Regret wrote, As you point out, no one correctly predicted that the world would look as it does now even 50 years ago.

Not completely true. IIRC the demographers involved at the beginning of Social Security project made some amazingly accurate projections.

[TJ Jackson]

The premise of this article is ridiculous. Lets take the first example cited about all those awful events. Prudent planning would indicate Martians aren't going to invade and destroy mankind and hence planning for retirement is required if one doesn't wish to send one's retirement in junior's guest room.

Now I am assuming you don't havve an approach to financial planning that is slightly to the Left of whoppee but stocks have returned an average of 10% over any twenty years period, and this amount is remarkably constant over a sixty year period.

If one doubts the advantages of investing in the market, who can cite a millionaire who followed the same investments that social security has over the past 60 years?

Further to the morons, and I use that term deliberately, who warn against investing in the market I would mention the market is a reflection of the US economy. To say this verges on being unpatriotic, but there aren't too many fools today who can say they've made money by betting against the US economy.

So allow me the use of my own money and let me invest it as I see fit. I'd rather have steak than dog food.

[TM]

Even if you stay at the peak of power indefinitely, you wouldn't be increasing your peak of powerness.

Evidently you have not seen Jim Glass at the gym.

[Liberal AND Proud]

Bush to increase defense 5% and cut Farm subsidies.

Let's all hear the cheers! What's he gonna cut next...childhealthcare? education grants...AGAIN?

What an AMERICAN!!

[martin]

As for SS-this blog operates at a level of abstraction far beyond the average congress(wo)man, much less American.

Remember the Istook Amendment which would allow he and his staff to look at tax returns? TM posted about it.

Well it was retracted. Istook was pissed and cut Amtrack funding. Northeastern Repubs were pissed in turn and forced Istook to surrender his chairmanship. This is the reality of Congress today (and all days)-it's very far from a rational discussion of ecomomic theory. (and now Bush wants to cut Amtrack-puh-leez).

So this is the political milieu in which SS will be decided, i.e. DOA. I will give you $5 for every quote you can cite from a congress-creature containing the phrase "equity risk premium."

See Kaus's post on Repubs angling for a quick defeat-(he's TM approved). That's the ticket.

[BuckBonzai]

TJ, stocks have had a zero return over a couple of 20 year periods.

That works out to a negative return compared with inflation, and a big negative return compared with treasury bonds.

I believe about negative six. But I don't believe anyone has this in a talking point, so you haven't heard it in that context.

More importantly, you can't extrapolate forward, except to guess a reasonable range, assuming conditions in the future are the same as in the past. We're presuming, at the least, that US population growth drop by about 1% a year of the next 50 years compared with the last 50. That will coincide with similar aging in most of the developed world. In China, the aged population will be even more heavily skewed negative - they project actual population decline among those entering the workforce. So, you have a couple new factors to toss in before you extrapolate forward.

Stocks are still smart to hold, particularly if you can hold stocks 40 years over your working life, but only if you can afford to be wrong.

[Jim Glass]

"TJ, stocks have had a zero return over a couple of 20 year periods. That works out to a negative return compared with inflation, and a big negative return compared with treasury bonds."

False, false and false.

Over all 20-year holding periods since 1802 stocks have never returned less than +1% annually over inflation, which is >+20% gain total.

Bonds have returned as little as -3% real annually, which is almost a 50%loss.

Jeremy Siegel has the data on this -- even Krugman quotes him!

And, of course, Social Security returns *less* than bonds.

"But I don't believe anyone has this in a talking point..."

Now you know why!

[Fred]

"...If Krugman & Co. succeed in convincing everyone that the only safe place to park their money is the SS Trust Fund..."

If that were literally true shouldn't he be pushing for the right to buy into the Social Security trust fund? If it's the only safe investment shouldn't all his savings be there?

[Jim Glass]

"Jim,

Given the relative size of the US economy I suspect that yes, GDP does act as a contraint. Where do you think the investment opportunities will come from? Mexico?"
~~~~~~

GT, why yes, certainly in part!

Baker's challenge is over *75 years*. China's GDP alone is projected to overtake the US's in 15 years. And then US GDP drops into low-growth mode. Is anyone investing in China?

So, 75 years from now, what will be the multiple of total Asian GDP to US GDP? And we might also ask what will be the ratio of Mexican and South American GDP to US GDP then, compared to today.

When talking of 75-years, let's not be short-sighted on demographics and trend lines.

#2) The whole issue is an irrelevant sideshow anyhow -- what matters is not opportunities to US corporations but to US *investors*.

If 30 years from now economies with 4 billion people in Asia, Latin America, Eastern Europe, etc., are growing a whole lot faster than the US's mere 2%, what will keep American individuals from investing in them?

Can Swedes invest only in Swedish corporations?

For that matter, returns on international investment markets equalize. Now if GDP growth rates really determine stock market growth rate, and the world growth rate considering Asia and all is 3.5% or 4%, what will be the magic mechanism that locks such out of US financial markets? Isolationism and capital controls??

[Harry Arthur]

"Bush to increase defense 5% and cut Farm subsidies.

Let's all hear the cheers! What's he gonna cut next...childhealthcare? education grants...AGAIN?

What an AMERICAN!!"

And, L&P, this is related to the topic being discussed how?

[TJ Jackson]

Buck Bonzai makes several false assumptions leading to a false conclusion. First he asks us not to make projections into the future based on past performance. Huh, exactly how does one make calculations and predictions unless one uses past data and makes logical and likely projections into the future?

He sounds rather like my kid brother who uses the same logic to justify spending every nickel he earns saying we don't know what the future holds so why save? Call me naive but somehow my crystal ball says kid brother had better marry well or his retirement is around age 80.

Bonzai also can't name a twenty year period starting with 1900-20, etc that my statement isn't true. People who bought stocks in 1933 made a fortune, even folks who bought in 2000 will probably do better than bondholder sby 2020. Bonds just do not perform.

The bottomline with Social Security it it extorts money from workers, defrauds them, and offers guarantees that are untrue. The Supreme Court has said no one has a legal right to social security.

Finally, one has reason to fear a government monopoly. The Left talks about tax increases and means testing to safeguard social security. Means testing, if you don't recognize these code words for what they mean to the average worker you probably believe in the Lock Box too.

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