Why you should expect lower stock returns in the future.
(Editor’s note… From time to time I try to explain important but complex issues from economic finance in 750 words, about five minutes reading time. I did that with inflation, the relationship between interest rates and bond prices, and what it means for news and information to be ‘priced into’ stocks. This is another one on ‘Equity Risk Premium’ and the ‘Risk Free’ rate the two most important numbers in all of investing.)
You know risk and reward are linked. You know you can expect additional return from risky stocks. How much extra return do you usually get from stocks and is it worth taking the risk? This is a subject academics have been looking at for decades and have many models.
Historically, that extra compensation, or ‘equity risk premium’ (ERP) of global stocks is about 5% more than ultra-safe investments like US Treasury bonds (the ‘risk-free’ rate). US Government bonds have usually been about 3%. Add the 5% and the 3% and you get the long term return of the global stock market about 8%.
The average investor has historically bought stocks if she thought she would get 5% more return than safe government bonds. Is 5% a lot or a little? This is the mystery! No one knows. It might have been 10% or 2% or 200%! ERP has a mystical reverence among academics because it was arbitrarily set by human preferences. And it’s been remarkably steady throughout the years.
Still, the ERP does vary some over time and we can use it as an estimate of investor fear. In the graph below, ERP is higher (more fear, more compensation required) in 2008 to 2012 during the great financial crisis and it’s lower (less fear, less compensation required) during the late-90s dot-com frenzy.
As you can see from the graph, the 2022 stock market ERP is in line with the historical average of 5% indicating that investors have average risk/fear expectations about stocks are right now about average compared to the past.
How is the ERP calculated? Let’s back up a bit.
When I invest in the shares of a company, I have reason (and/or faith) that the company will perform well enough in the future to justify the price I pay. Stocks confer ownership indefinitely, so I can look deep into the future and count how much profit I think I will get back based on economic and company performance forecasts.
The estimate is anything but guaranteed. Sometimes I am right about my estimate, sometimes I am not. Companies make a lot of mistakes, can languish for decades, and economic forecasts are perpetually wrong. The largest stocks of 2005 were GE and Exxon!
Though I own the shares forever, I have no assurances or contract about my investment returns. In fact, if things go really wrong and they file for bankruptcy, they might cease to exist, and stockholders usually lose their entire investment as they probably will with Revlon, which filed last week.
By contrast, bonds are predictable and safe and assured although they are not 100% safe of course. The big news in this bear market is that bonds are doing poorly. Bonds are huge loans to companies that get cut apart and sold off in little bits. Each bit is a ‘bond’ and represents a micro portion of the total loans to the company. If I buy a bond, I’m entitled to be paid back with interest. Each bond specifies highly regular payments for a fixed period of time at a guaranteed interest rate.
Bonds are not risk-free but compared to stocks there are substantial assurances and legal protections for the payments. And in bankruptcy you get some of your investment back. (usually)
You can make bonds nearly ‘risk free’ by purchasing the government bonds of a financially stable developed country, often US Treasury bills. And the return is considered guaranteed because the chance the U.S. government will go bankrupt or choose not to honor the terms is considered extremely low. (Yes, they can inflate away their debts. That’s a future blog.)
The risk-free rate is an important number in financial economics because it represents (theoretically, at least) a minimum expected investment return that any rational investor should accept. After all, why would you ever take less than the safest interest rate you could make? By definition, all the other investment opportunities are riskier, and you should be rewarded with something over the risk-free rate as compensation.
We pointed out above that the 5% ERP is somewhat arbitrary. Will the equity risk premium of 5% persist? Obviously, we don’t know, but those more knowledgeable believe we should be prepared for the ERP to be a little lower in the future because markets are easier and safer to invest in than they were in the past. This should reduce overall risk and, therefore, what investors require as compensation. But we don’t have any reason to think the ERP will disappear entirely.
Humans continue to want to be compensated for the investment risks they take.
