Economics: How Risky Is The Risk Premium?

Economists square off over stock volatility

Over the past 75 years, stocks have outperformed bonds and other debt securities by a huge margin. The annual return on a broad portfolio of stocks has averaged 9 percentage points more than the return on risk-free U.S. Treasury bills. With that glorious history in mind, many investment advisers are saying that the longer your investment horizon is, the more you should be in stocks--right on up to 100% of your portfolio.

But beware: Many finance scholars say that investors would be making a big mistake to assume that stocks will earn them 9%--or even 7%--a year above the rate on T-bills. Past performance, they say, is no guarantee of future returns.

For long-range planning, the debate about the merits of stocks vs. Treasury bills or bonds boils down to what economists call the "equity risk premium." This is a tricky and often misunderstood concept. In a nutshell, it's the extra return that investors want and expect to receive from stocks because of the higher volatility of stock prices. Let's say you're choosing between a stock that fluctuates a lot in price and a bond that's more stable. Because you dislike volatility, you'll pay less for the stock than for the bond. And because your cost basis is lower for the stock, the total annual return will be higher.

What makes the equity premium such a puzzle is why it's so big, given that stocks are only slightly more volatile than bonds. After all, bond returns fluctuate, too. What's more, the tax system favors stocks over bonds. Wrestling with this puzzle, some people have concluded that the equity premium is a case of mass delusion--one that's about to end. That's the thesis of James K. Glassman and Kevin A. Hassett's best-selling book, Dow 36,000. The two scholars at the American Enterprise Institute, a conservative think tank, say the equity risk premium is unjustified--i.e., stocks are too low--because in the long run, stocks aren't more volatile than bonds. They argue that investors will soon catch on to that fact and will be content to receive the same low return from stocks that they get from bonds. The cute part is how we get from here to there. Stock prices will need to be higher than they are now, so people who buy stocks in the future will have a smaller upside on their investment. That implies a huge but one-time-only leap in prices. They advise readers to buy before the leap, because after it, stock returns will be as low as bond returns. When they published in September, 1999, they predicted the Dow would hit 36,000 in three to five years.

MEASURING THE PREMIUM. But critics question whether investors will ever be content to earn as little from stocks as they earn from bonds. As a result, they doubt that the leap in prices that Glassman and Hassett forecast will ever take place. Says Robert D. Arnott, managing partner of First Quadrant, a Pasadena (Calif.) asset manager: "Their core thesis completely overlooks the fundamental reality of why people own stocks."

What makes the equity premium so hotly debated is that there's no direct way to measure it. If you can't be sure how big it is now, you certainly can't know how big it will be in the future. For example, many people assume that stocks' historical 9% edge over T-bills is a good indicator of what their future outperformance will be. But who knows? Maybe stocks have been rising in part because people have been losing their fear of stock volatility. The two-decade-long bull market probably caused people to become less fearful of stocks and shrank the risk premium they demanded, says Harvard University economist John Y. Campbell. He thinks that if the mood changes for the worse, the premium will get bigger again, albeit not quite to its original size. People will demand to be compensated for stocks' riskiness, and that will put downward pressure on stock prices.

Theories for why the equity premium is so big range across the board. In a recent paper, Stephen Cecchetti and two co-authors from Ohio State University say that investors use a rule of thumb for decisionmaking that makes them overly pessimistic about the likelihood that good times will continue--so they're afraid to own stocks. Other scholars finger "disappointment aversion," saying that investors shy away from the volatility of stocks because they dislike losses more than they like gains.

An easier way to resolve the puzzle is to say that it's a case of mistaken identity--that the premium isn't as big as it appears from looking at the historical data. Eugene F. Fama of the University of Chicago and Kenneth R. French of Massachusetts Institute of Technology argue that the risk premium over the past half-century was only 4%. Their calculation is based on going back to the past and analyzing what kinds of returns investors had a reasonable right to expect for the future, given companies' dividend yields and expected dividend growth rates. The return they got exceeding 4% was, they say, the result of a series of surprises, such as the end of the cold war and the development of the computer--windfalls that can't be counted on to repeat themselves. They expect stocks to outperform risk-free securities by only 3% to 3.5% a year in the long term, and by less than 1% in the short term.

Among the people who have studied the equity premium closely, most think it is probably no more than a few percentage points above Treasury bills. But their skepticism hasn't filtered out to investors, advisers, or even rank-and-file finance professors, who still peg the long-term premium at 7%, according to a survey published last year by Ivo Welch, then a professor at UCLA's Anderson School and now of Yale University. If those high estimates turn out to be wrong, a lot of investors are in for a lot of pain.

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