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Monday Morning: Don’t expect a big risk premium on equities

Stocks are riskier than bonds, as every investor probably understands by now. But how much riskier are they?…

Stocks are riskier than bonds, as every investor probably understands by now. But how much riskier are they?

And how much additional return should stocks pay to investors over bond returns for taking the additional risk? In other words, what is the appropriate risk premium?

Over the past 75 years, U.S. equities have produced real (i.e., inflation-adjusted) returns of 8% compounded annually, outpacing bonds by almost 5% over the period. That is, the equity risk premium has been about 5% a year.

So if history were to repeat itself, equity investors would be able to expect returns of 8% plus the inflation rate, currently about 3% a year.

An 11% annual return on equities over the long run should be enough for any investor, yet surveys suggest many investors still expect long-term returns of up to 20% per year despite the market correction of late last year and this year’s first quarter.

Robert D. Arnott, managing partner of First Quadrant in Pasadena, Calif., argues that even the deflated 5% that equities returned in excess of bonds over the past 75 years does not represent a “normal” risk premium.

Mr. Arnott, who a few months back argued that equity investors could expect a negative equity risk premium for the immediate future because of the exceptionally high equity returns in recent years, says investors in 1925 would not have expected an equity risk premium as high as the 5% achieved.

The lofty risk premium, he says, was a result of a series of happy historical accidents that “uniformly helped stocks and/or helped the risk premium.”

The first of the historical accidents was the United States’ going off the gold standard. At the time, bonds yielded 3.7% (real, as no inflation was expected under the gold standard) and stocks yielded 5.4% (also real).

Stockholders in the era of the robber barons expected little participation in the growth of a company or from rising valuations. Therefore the risk premium by the end of 1925 was only 1.7%. The abandonment of the gold standard decoupled real and nominal yields.

The second historical accident was stocks’ going from a valuation of 18 times dividends to more than 70 times dividends.

“This … increase in the value assigned to each dollar of dividends contributes 1.5% to the annual returns over the past 75 years, even though the entire increase occurred in the last 18 years of the period,” Mr. Arnott says.

Third, no wars have been fought on American soil since the Civil War, and the United States has experienced no revolution. “The U.S. investors of 1925 would not have counted this likelihood as zero. Nor should today’s long-term investor,” Mr. Arnott says.

Fourth, stocks have gone from passing essentially no economic growth through to shareholders to passing most of the economic growth through to them. This, Mr. Arnott calculates, explains 20% of the 75-year excess return.

“In short,” says Mr. Arnott, “the 1925 equity investor likely expected to earn a real return no larger than their 5.4% yield and expected to earn no more than the 1.7% yield differential over bonds.” That is why the equity risk premium in 1925 was only 1.7%.

In addition, as Mr. Arnott points out, the real return on stocks and the equity risk premium have both been negative for significant periods in the past. The real return on stocks was negative over most 10-year spans during the two decades from 1962 to 1983, and the excess return of stocks relative to bonds was negative as recently as 1984 through 1993.

Mr. Arnott calculates that the normal equity risk premium is not the 5% of the past 75 years, but “a very modest (and sensible) 2%. A 2% risk premium is quite sufficient to justify equity market risk,” he says.

Yes, but justify to whom? Maybe not the investors that financial advisers deal with every day. Instead of the historic 5% risk premium, they are used to the approximately 10% risk premium of the past 15 years.

Explaining to those investors that they shouldn’t expect stocks to outperform bonds by such huge margins in the future, and that therefore stock returns are likely to be much lower, will require high-level diplomatic and persuasive skills.

Mike Clowes is the editorial director of InvestmentNews