Is there any proof of correlation between risk & return?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
User avatar
Lbill
Posts: 4997
Joined: Thu Mar 13, 2008 11:25 pm
Location: Somewhere between Up and Down

Is there any proof of correlation between risk & return?

Post by Lbill » Fri Sep 02, 2011 8:05 pm

The following quote is from a working paper by economist Eric Falkenstein entitled "Why Risk is not Related to Returns", 2007. It was formerly available for download from SSRN. There is a more extensive paper available entitled "Risk and Return in General: Theory and Evidence" that is available for download. The author makes a strong argument that, outside of a few special cases, there is no general evidence to support the commonly accepted wisdom that there is a positive correlation between investment risk and investment returns. Taking investment risk - for the most part - goes unrewarded, except when you're lucky.
For 40 years researchers have looked for corroborating evidence of risk and reward having a positive and a linear relationship within publicly traded equities, initially looking at betas derived against the US market indices versus realized returns. Since Eugene Fama and Kenneth French’s seminal 1992 study documenting how the relation between beta and returns is essentially flat, many have accepted there simply is no correlation between beta and cross sectional returns as a practical matter. If risk is positively related to expected return, people’s perception of risk must be like facial recognition, intuitive and common, yet exceedingly difficult to model; there is no measure of risk that produces a consistent linear scatter plot with returns.
"Life can only be understood backward; but it must be lived forward." ~ Søren Kierkegaard | | "You can't connect the dots looking forward; but only by looking backwards." ~ Steve Jobs

User avatar
Taylor Larimore
Advisory Board
Posts: 27505
Joined: Tue Feb 27, 2007 8:09 pm
Location: Miami FL

Post by Taylor Larimore » Fri Sep 02, 2011 8:31 pm

Hi LBill:
The author makes a strong argument that, outside of a few special cases, there is no general evidence to support the commonly accepted wisdom that there is a positive correlation between investment risk and investment returns.
I have not read the book, but nearly everything I know suggests that there is a big correlation between risk and return. The evidence is easily seen in bonds where additional yield is nearly always accompanied with additional risk of loss.

This is a good explanation for the correlation of stock risk and return:
MPT assumes that investors are risk averse, meaning that given two portfolios that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher expected returns must accept more risk. The exact trade-off will be the same for all investors, but different investors will evaluate the trade-off differently based on individual risk aversion characteristics. The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-expected return profile – i.e., if for that level of risk an alternative portfolio exists which has better expected returns.
http://en.wikipedia.org/wiki/Modern_por ... ted_return

What evidence does the author present to support his contrary position?

Thank you.
"Simplicity is the master key to financial success." -- Jack Bogle

SP-diceman
Posts: 3968
Joined: Sun Oct 05, 2008 9:17 am

Re: Is there any proof of correlation between risk & ret

Post by SP-diceman » Fri Sep 02, 2011 9:05 pm

Lbill wrote: Taking investment risk - for the most part - goes unrewarded, except when you're lucky.
Don’t you also need a timeframe?
Risk vs. return over 1 year, 5 years, 10 years, forever?

Seems to me time would be important.



Thanks
SP-diceman

User avatar
GregLee
Posts: 1748
Joined: Wed Oct 27, 2010 3:54 pm
Location: Waimanalo, HI

Re: Is there any proof of correlation between risk & ret

Post by GregLee » Fri Sep 02, 2011 10:04 pm

Lbill wrote:
For 40 years researchers have looked for corroborating evidence of risk and reward having a positive and a linear relationship ...
Why should the relationship be linear? Even if there is no positive linear relationship between risk and reward, that wouldn't show that there is no relationship between the two.
Greg, retired 8/10.

User avatar
VictoriaF
Posts: 18597
Joined: Tue Feb 27, 2007 7:27 am
Location: Black Swan Lake

Post by VictoriaF » Fri Sep 02, 2011 10:14 pm

Taylor Larimore wrote:Hi LBill:
The author makes a strong argument that, outside of a few special cases, there is no general evidence to support the commonly accepted wisdom that there is a positive correlation between investment risk and investment returns.
I have not read the book, but nearly everything I know suggests that there is a big correlation between risk and return. The evidence is easily seen in bonds where additional yield is nearly always accompanied with additional risk of loss.
Hi Taylor,

Bonds are indeed a good example of the correlation of risks and returns.

Taylor Larimore wrote:This is a good explanation for the correlation of stock risk and return:
MPT assumes that investors are risk averse, meaning that given two portfolios that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher expected returns must accept more risk. The exact trade-off will be the same for all investors, but different investors will evaluate the trade-off differently based on individual risk aversion characteristics. The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-expected return profile – i.e., if for that level of risk an alternative portfolio exists which has better expected returns.
http://en.wikipedia.org/wiki/Modern_por ... ted_return

What evidence does the author present to support his contrary position?

Thank you.
Increasingly, behavioral evidence shows that investors are not rational, and thus their evaluation of risks and returns may be highly skewed. The question is to what degree the behavioral factors reduce the correlation between risks and returns.

Victoria
WINNER of the 2015 Boglehead Contest. | Every joke has a bit of a joke. ... The rest is the truth. (Marat F)

Indices
Posts: 1031
Joined: Sun Sep 27, 2009 11:40 am
Contact:

Post by Indices » Fri Sep 02, 2011 10:18 pm

No there is no correlation. I am increasingly convinced that virtually all investments given enough time return about the rate of inflation possibly less. Sadly the risk/return relationship is one of the biggest myths on this forum.

Most people invest because they think they can make a quick buck or get rich. They don't invest in stocks because there is a risk premium. That is academic/Boglehead thinking.

User avatar
Taylor Larimore
Advisory Board
Posts: 27505
Joined: Tue Feb 27, 2007 8:09 pm
Location: Miami FL

Risk and Return correlation.

Post by Taylor Larimore » Sat Sep 03, 2011 6:23 am

Indices wrote:No there is no correlation. I am increasingly convinced that virtually all investments given enough time return about the rate of inflation possibly less. Sadly the risk/return relationship is one of the biggest myths on this forum.
Hi Indices:

The chart in the link below (Figure 1.2) in Mr. Bogle's book, Common Sense on Mutual Funds, shows the risk (jagged vs. smooth lines) and real return of stocks, bonds, and gold, plus the effect of inflation from 1802 to 2008.

Total Real Return on $10,000 initial Investment

You can see, the different investments do not "return the rate of inflation possibly less." The return of stocks and bonds and gold is vastly different over longer periods and all beat inflation.

The correlation of Risk and Return is not a "myth."
"Simplicity is the master key to financial success." -- Jack Bogle

User avatar
Lbill
Posts: 4997
Joined: Thu Mar 13, 2008 11:25 pm
Location: Somewhere between Up and Down

Post by Lbill » Sat Sep 03, 2011 8:22 am

Bonds are indeed a good example of the correlation of risks and returns.
But why do you say that? One of the author's findings is this:
the returns to a funded position in bonds, an excess return, is very close to zero. Indeed, buying 6-month T-bills funded at the Fed Funds rate was a money loser, and for the 1-year bond, about a zero return. But returns are increasing over maturity. Yet, the increase in yield from 5 years to 10 years is miniscule, around 20 basis points, and only 9 basis points from 10 to 20 years. The price volatility, meanwhile, increases consistently as maturity increase, and thus the Sharpe ratio peaks around 3 to 5 years.
So, it's pretty clear that accepting risk in bonds is positively related to returns up to maturities of 3-5 years, but for higher maturities all you get is more risk without any predictable profit. But, this is actually pretty obvious isn't it?
"Life can only be understood backward; but it must be lived forward." ~ Søren Kierkegaard | | "You can't connect the dots looking forward; but only by looking backwards." ~ Steve Jobs

Indices
Posts: 1031
Joined: Sun Sep 27, 2009 11:40 am
Contact:

Post by Indices » Sat Sep 03, 2011 8:24 am

Taylor, past performance is not indicative of future returns. Is this true across every stock index in the world? There are no "rules" when it comes to returns. I'm sure many Cuban share owners are still waiting for their market to reopen.

I could data mine just 19th century data (which is largely incomplete) and say bonds always outperform stocks. Just as most people on this board data mine the last 70 years of data to "prove" small cap value outperforms or there is some sort of equity risk premium.
Last edited by Indices on Sat Sep 03, 2011 8:32 am, edited 2 times in total.

User avatar
Lbill
Posts: 4997
Joined: Thu Mar 13, 2008 11:25 pm
Location: Somewhere between Up and Down

Post by Lbill » Sat Sep 03, 2011 8:24 am

What evidence does the author present to support his contrary position?
Well... there's always the guy's paper, which I linked.
"Life can only be understood backward; but it must be lived forward." ~ Søren Kierkegaard | | "You can't connect the dots looking forward; but only by looking backwards." ~ Steve Jobs

User avatar
SVariance1
Posts: 1217
Joined: Mon Jun 20, 2011 11:27 am
Location: Philadelphia Area

Post by SVariance1 » Sat Sep 03, 2011 8:34 am

There is correlation between risk and return. My own theory about the relationship (supported by nothing scientific at all) is that it is linear initially but the transforms into somewhat of a curve. It is straight when one goes from bonds to stocks but then the shape changes within equities. You get a diminishing rate of increase in return for every unit of risk and in some cases you get very little for taking extra risk.
Mike

User avatar
Lbill
Posts: 4997
Joined: Thu Mar 13, 2008 11:25 pm
Location: Somewhere between Up and Down

Post by Lbill » Sat Sep 03, 2011 8:41 am

Perhaps an "appetizer" will lure a few to make the effort to don their thinking cap and read the author's paper (he said doubtfully):
Risk premiums are presumably omnipresent and extremely difficult if not impossible to measure. This paper outlines the origin of the modern theory of risk premiums, the history of its testing, and surveys the current failure of this theory across over 20 different asset classes.

The idea that risk is priced is highly intuitive, and implied by globally concave utility functions, which are also highly intuitive as a general rule. Yet the empirical support for a priced risk premium is absent across a large spectrum of investable assets (this excludes catastrophic insurance premium which are outside this analysis). The empirical anomalies to the high risk-high return hypothesis are not exceptions to a general tendency: There is no general tendency within a variety of investments, such as equities, individual equity options, most of the yield curve, high yield corporate and bankrupt bonds, mutual funds, commodities, small business owners, movies, lottery tickets, and horse races. Indeed, it seems many very high risk assets contain some extra attribute. It is possible the equity premium is actually zero after suitable adjustments for transaction costs and selection biases, and the other two prominent examples of a positive risk-return tradeoff — the short end of the yield curve, the spread on investment grade bonds — do not generalize when extended in the ‗risk‘ spectrum for these asset classes.

The belief that risk, properly measured, must be positively related to returns is very deep among academics. Risk is supposedly not only important and everywhere, but subtle, requiring that investors implicitly have skills similar in sophistication and imprecision to what is needed to distinguish between a good and great wine.

As the saying goes, one has to take risk to generate high returns, but there is no greater expected return merely for taking risk of any sort.
Last edited by Lbill on Sat Sep 03, 2011 8:53 am, edited 1 time in total.
"Life can only be understood backward; but it must be lived forward." ~ Søren Kierkegaard | | "You can't connect the dots looking forward; but only by looking backwards." ~ Steve Jobs

Indices
Posts: 1031
Joined: Sun Sep 27, 2009 11:40 am
Contact:

Post by Indices » Sat Sep 03, 2011 8:45 am

If there was a correlation why did it not exist for the first 60+ years of stock returns in the 19th century and then suddenly appear like magic? In the latter half of that century Americans finally got their act together and started having sustained economic and population growth and so stocks went up accordingly. This continued for decades until recently. I don't think it had anything to do with some innate "risk premium" inherent in stocks.

If we continue to have big population growth through immigration we'll continue to have stock growth. If we close off our borders and let our declining birth rates take over, like they have in Japan, then we'll have a declining economy and declining stock market for the forseeable future, again like the Japanese.

User avatar
MossySF
Posts: 2303
Joined: Thu Apr 19, 2007 9:51 pm
Contact:

Post by MossySF » Sat Sep 03, 2011 8:51 am

There is correlation in one direction. To get more return, you must take more risk.

There is no correlation the other way. The house wins, you lose.

yobria
Posts: 5978
Joined: Mon Feb 19, 2007 11:58 pm
Location: SF CA USA

Post by yobria » Sat Sep 03, 2011 8:52 am

Of course more risk = more expected (and usually actual as well) return.

Stocks, for example, have higher risk and higher returns in every country with long term data.
Lbill wrote:So, it's pretty clear that accepting risk in bonds is positively related to returns up to maturities of 3-5 years, but for higher maturities all you get is more risk without any predictable profit. But, this is actually pretty obvious isn't it?
What's obvious is that, assuming a normal (upward sloping) yield curve (which is almost always the case), a 20 year bond purchased today will have a higher yields, and thus a higher expected return, than at 5 year. You do know how well long term bonds have done over the past few years, right?

Similarly, small cap stocks have been more volatile, yet have had higher returns, than large caps over the long term, in most countries.

Nick

afan
Posts: 3872
Joined: Sun Jul 25, 2010 4:01 pm

Post by afan » Sat Sep 03, 2011 8:52 am

I think we need to read the entire papers, not just a few sentences excerpted from them. There is abundant evidence that risk correlates with return. F&F's point is that adding size and value to the regression eliminates any RESIDUAL correlation between risk and return.

They are not saying that there is no relationship between beta and return in a univariate regression. They are saying that size and value explain all the predictable return in 3-factor (beta, size, value) regression. Very different claim than "no correlation between risk and return"

Indices
Posts: 1031
Joined: Sun Sep 27, 2009 11:40 am
Contact:

Post by Indices » Sat Sep 03, 2011 8:55 am

yobria wrote:
Similarly, small cap stocks have been more volatile, yet have had higher returns, than large caps over the long term, in most countries.

Nick
But not in all countries. That shows obvious data mining. For something to be true it must be true in all countries, all the time. Otherwise it's not true/universal.

The graph Taylor links to in "Commonsense on Mutual Funds" clearly shows that bonds and stocks had identical returns for 60 plus years in the 19th century. Where was the "risk premium" then? Why did it magically appear later? Does it "turn off" for decades at a time? That is an odd phenomena if so.

My feeling is that the risk premium was created to justify holding a portfolio made up mostly of stocks indefinitely. It worked for most of the 20th century, why not forever? But that is basing future returns on past performance. And we all know that is the wrong way to go.

User avatar
Lbill
Posts: 4997
Joined: Thu Mar 13, 2008 11:25 pm
Location: Somewhere between Up and Down

Post by Lbill » Sat Sep 03, 2011 9:08 am

What's obvious is that, assuming a normal (upward sloping) yield curve (which is almost always the case), a 20 year bond purchased today will have a higher yields, and thus a higher expected return, than at 5 year. You do know how well long term bonds have done over the past few years, right?
Gee, that's not nearly as persuasive as the research data presented by the author. We're talking about the relationship between risk and return. It's pretty clear that you assume much higher risk with long-maturity bonds, and you might get rewarded for that with a higher return (if you're lucky). But just because an investment has a higher return doesn't prove that was the result of higher assumed risk. The fact that long bonds have done well in recent times doesn't obscure the fact they were horrible investments during long periods of time.
"Life can only be understood backward; but it must be lived forward." ~ Søren Kierkegaard | | "You can't connect the dots looking forward; but only by looking backwards." ~ Steve Jobs

Indices
Posts: 1031
Joined: Sun Sep 27, 2009 11:40 am
Contact:

Post by Indices » Sat Sep 03, 2011 9:14 am

Where is the equity risk premium in Japan for the past twenty years and counting? Or the US for the past 11 years and counting?

yobria
Posts: 5978
Joined: Mon Feb 19, 2007 11:58 pm
Location: SF CA USA

Post by yobria » Sat Sep 03, 2011 9:19 am

Indices wrote:
yobria wrote:
Similarly, small cap stocks have been more volatile, yet have had higher returns, than large caps over the long term, in most countries.

Nick
Indices wrote:But not in all countries. That shows obvious data mining. For something to be true it must be true in all countries, all the time. Otherwise it's not true/universal.
a) Which countries are you refering to? Long term (100 year) results show a positive actual risk premium (ARP) in all countries with such data:

http://faculty.london.edu/edimson/asset ... /Jacf1.pdf

b) The ARP doesn't have to be positive for all countries over all time periods for the ERP to be positive. The risk does show up at times.
Indices wrote:The graph Taylor links to in "Commonsense on Mutual Funds" clearly shows that bonds and stocks had identical returns for 60 plus years in the 19th century. Where was the "risk premium" then?
19th century data doesn't show anything "clearly", I'm afraid. We only have somewhat reliable stock return data from 1927 onward, and even that is suspect in the small cap area.

And again, in some cases, over some time periods, the risk may show up. I may be able to beat Tiger Woods at golf 1/100 times. Doesn't mean I expect to beat him, on average,going forward.
Indices wrote:My feeling is that the risk premium was created to justify holding a portfolio made up mostly of stocks indefinitely. It worked for most of the 20th century, why not forever? But that is basing future returns on past performance. And we all know that is the wrong way to go.
No, that's basing future returns on plain old common sense. A rational investor will never demand a higher return from a lower risk asset class.

Nick

Indices
Posts: 1031
Joined: Sun Sep 27, 2009 11:40 am
Contact:

Post by Indices » Sat Sep 03, 2011 9:23 am

We have reliable data from 1871 onwards. We also have reliable foreign data that is older. The 1927 date is used to data mine all kinds of things like the equity premium and the advantage of SCV.

Look if stocks produce a 6 per cent return on average ever year, and the stock market opened in 1792, we can extrapolate from that where the Dow should be using compounding. We don't need to have all the data. If we say we start at 1 in 1792, compound 6 per cent per year what do we get? Do we get 11200 which is what the Dow is at now? No we get a lot higher. Clearly stock returns were terrible for decades before the data we do have, otherwise we wouldn't be "just" at 11200 or so. And this largely coincides with the chart Taylor links to: stock returns were terrible for decades in the first half of the 19th century. There was no equity risk premium.

People buy stocks because they think they can get rich or make a quick buck. They don't even know what the terms "equity risk premium" or "risk/return ratio" means. That is Boglehead thinking.

If there was an equity risk premium, why are investors so stupid and not buying up something that is guaranteed to have a higher expected return? Why are they buying bonds? Because they think they can get a better short term deal.

User avatar
Opponent Process
Posts: 5157
Joined: Tue Sep 18, 2007 9:19 pm

Post by Opponent Process » Sat Sep 03, 2011 9:33 am

MossySF wrote:There is correlation in one direction. To get more return, you must take more risk.

There is no correlation the other way. The house wins, you lose.
I think it has to be something like this, some kind of rectifying function. I agree that you can't just say they are correlated. to say that all you have to do to get more guaranteed return is to dial up risk seems incorrect. at least by one definition it wouldn't be "risk" if you were absolutely guaranteed the return.

there's also a ton, a ton, of survivorship bias in historical returns, similar to active fund management returns. you have to win all the wars, elect all the right leaders, etc. to get the payoff, and you simply can't predict these things. things like political risk is where a lot of the risk and return comes from, not some magical inherent properties of a set of securities. people who try to describe the latter are simply blinded by their privilege and bias, patting themselves on the back for being born in the right place at the right time. the only thing we can accurately glean from history is that markets are constantly turned over, with the new victors pretending to extrapolate accurate calculations of the future based on some supposed self-satisfied superiority. but these things are more cyclical than linear. like it or not history is actively managed, with all the associated risks! if only it were passively managed.
30/30/20/20 | US/International/Bonds/TIPS | Average Age=37

zeugmite
Posts: 1053
Joined: Tue Jul 22, 2008 11:48 pm

Post by zeugmite » Sat Sep 03, 2011 9:36 am

Lbill wrote:
As the saying goes, one has to take risk to generate high returns, but there is no greater expected return merely for taking risk of any sort.
This isn't surprising because I don't expect greater return for taking just any risk, or there wouldn't be an efficient frontier. I think individual-asset risk/return will be enormously complicated because assets are not independent, whether due to uncertainty, behavioral issues, or more likely, economics. I never expected the risk/return trade off to work for a single asset, but given a series of portfolios of varying risks and returns (even if they are related the "wrong way"), you can always construct a concave efficient frontier of "best portfolios" where risk scales with return.

zeugmite
Posts: 1053
Joined: Tue Jul 22, 2008 11:48 pm

Post by zeugmite » Sat Sep 03, 2011 9:51 am

pwm112 wrote:I don't know if I agree with your premise of extrapolating back indefinitely to disprove the existence of an inherent risk premium.
This 'paradox' is resolved easily by noting that people do spend the money in their portfolio and do not let it 'compound' forever.

Alex Frakt
Founder
Posts: 10853
Joined: Fri Feb 23, 2007 1:06 pm
Location: Chicago
Contact:

Post by Alex Frakt » Sat Sep 03, 2011 10:23 am

Indices wrote:Where is the equity risk premium in Japan for the past twenty years and counting? Or the US for the past 11 years and counting?
Neatly illustrating recency bias - the behavioral tendency to overweight the importance of recent events.

You don't need advanced math to understand risk premia. The basis of any investment is an understanding of the likely return and the risks involved in achieving them. The lower the latter, the lower the price you should be willing to pay. Index investing obscures this, but even index investments are based on the collective judgement of others who have made this calculation.

Since this is still kind of fuzzy, let's look an example from the early days of investing. You are sitting in a coffeeshop in London or Amsterdam. A ship owner comes to you to back an upcoming 1 year voyage. He needs 100 bars of silver to complete his financing. Based on the past history of this trading trip, owner, vessel and captain, you calculate that there is a 75% chance the voyage will produce a profit of 400 bars of silver and a 25%, chance there will be no profit at all, for an expected profit of 300 bars. Assuming you can receive a 5% return from the safest loan in the land, what percentage of the profits would you demand to back the voyage? If there were no such thing as a risk premium, you would only demand 105/300 (35%) of the profit, the same expected return you would get from making the loan. If you would demand a higher percentage (and any rational person would), then you are asking for a risk premium.

zeugmite
Posts: 1053
Joined: Tue Jul 22, 2008 11:48 pm

Post by zeugmite » Sat Sep 03, 2011 10:42 am

pwm112 wrote:
zeugmite wrote:This 'paradox' is resolved easily by noting that people do spend the money in their portfolio and do not let it 'compound' forever.
Yeah but shouldn't that drive down the price, thus eliminating the "premium".
I think what I meant was that the index -- if you calculate it to include all dividends reinvested -- could increase at a faster rate than the general economy (to allow the risk premium), but that it would not imply that wealth becomes concentrated.

Indices
Posts: 1031
Joined: Sun Sep 27, 2009 11:40 am
Contact:

Post by Indices » Sat Sep 03, 2011 11:07 am

Alex Frakt wrote:
Indices wrote:Where is the equity risk premium in Japan for the past twenty years and counting? Or the US for the past 11 years and counting?
Neatly illustrating recency bias - the behavioral tendency to overweight the importance of recent events.

You don't need advanced math to understand risk premia. The basis of any investment is an understanding of the likely return and the risks involved in achieving them. The lower the latter, the lower the price you should be willing to pay. Index investing obscures this, but even index investments are based on the collective judgement of others who have made this calculation.
But Alex, using 75 years of data is also recency bias. I could point to 60 years of data from the early 19th century where stock and bond returns were identical. I could point to the 50 plus years of zero returns from the Cuban stock market. I could point to any data set to make a point. There are no expected returns and so there are no risk/return correlations.

The vast majority of investors do not think like you do. They all use recency bias to make stock picks or buy stocks at all. No one says, "oh I know that I have a higher expected return with this asset class". That is the same as saying I am guaranteed higher returns with stocks. If that were the case then everyone would be a buy and hold investor.
Last edited by Indices on Sat Sep 03, 2011 11:36 am, edited 1 time in total.

Indices
Posts: 1031
Joined: Sun Sep 27, 2009 11:40 am
Contact:

Post by Indices » Sat Sep 03, 2011 11:09 am

pwm112 wrote:
Indices wrote:We have reliable data from 1871 onwards. We also have reliable foreign data that is older. The 1927 date is used to data mine all kinds of things like the equity premium and the advantage of SCV.

Look if stocks produce a 6 per cent return on average ever year, and the stock market opened in 1792, we can extrapolate from that where the Dow should be using compounding. We don't need to have all the data. If we say we start at 1 in 1792, compound 6 per cent per year what do we get? Do we get 11200 which is what the Dow is at now? No we get a lot higher. Clearly stock returns were terrible for decades before the data we do have, otherwise we wouldn't be "just" at 11200 or so. And this largely coincides with the chart Taylor links to: stock returns were terrible for decades in the first half of the 19th century. There was no equity risk premium.
How do you know you should start at 1 in 1792 as opposed to 0.001? Also isn't 6% supposed to be the average return above inflation (yet your Dow numbers are nominal)?

I don't know if I agree with your premise of extrapolating back indefinitely to disprove the existence of an inherent risk premium. For example, what might we reason would have been a good investment for the common man in the middle ages? Answer: Nothing because the common man was basically a slave to his landlord. Does that mean the entire concept of investment in anything at all is flawed? I don't think so because individuals today have greater access to the inherent benefits of nature than they have in the past.
I am not completely sure they used 1, but it is probably likely simply because it is the easiest to work with. Regardless I think most people assume we will 9.5 per cent annual average returns going forward. Use that number instead of 6. You can see how there has to have been a long period of time where stock returns were terrible.

User avatar
Drain
Posts: 1397
Joined: Mon Feb 26, 2007 1:27 pm
Location: Maryland

Post by Drain » Sat Sep 03, 2011 11:24 am

Taylor Larimore wrote:I have not read the book, but nearly everything I know suggests that there is a big correlation between risk and return. The evidence is easily seen in bonds where additional yield is nearly always accompanied with additional risk of loss.
The quote in the original post says "equities".
Darin

Dandy
Posts: 5400
Joined: Sun Apr 25, 2010 7:42 pm

Post by Dandy » Sat Sep 03, 2011 11:39 am

Normally, safe Treasury securities have a higher nominal interest rate the longer the term. Doesn't that support a higher reward for a higher inflation risk and interest rate increase risk?

Now when you get to equities the level of risk is much harder to determine. Is Google or Apple riskier than GE or Exxon? Projected earnings per share are not that good and basing it on prior earnings are not much better. What is the competition doing? So, it is probably true that reward is related to risk but how do you determine the "true" or accurate comparative level of risk for equities.

pkcrafter
Posts: 13095
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Post by pkcrafter » Sat Sep 03, 2011 11:51 am

Indices wrote:
yobria wrote:
Similarly, small cap stocks have been more volatile, yet have had higher returns, than large caps over the long term, in most countries.

Nick
But not in all countries. That shows obvious data mining. For something to be true it must be true in all countries, all the time. Otherwise it's not true/universal.

The graph Taylor links to in "Commonsense on Mutual Funds" clearly shows that bonds and stocks had identical returns for 60 plus years in the 19th century. Where was the "risk premium" then? Why did it magically appear later? Does it "turn off" for decades at a time? That is an odd phenomena if so.

My feeling is that the risk premium was created to justify holding a portfolio made up mostly of stocks indefinitely. It worked for most of the 20th century, why not forever? But that is basing future returns on past performance. And we all know that is the wrong way to go.
It seems what you are describing is risk. IF small caps always outperformed in all years and in all countries you would get a guaranteed premium, which means a riskless investment. If stocks always outperformed bonds, there would be no risk in owning them. The fact is to get investors to put money into something, there must be some incentive to make them do it. And they need to realize when they do it there is a risk they won't get the hoped-for profit.
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

VennData
Posts: 575
Joined: Mon Feb 26, 2007 5:52 pm

Post by VennData » Sat Sep 03, 2011 11:54 am

Opponent Process wrote:...like it or not history is actively managed, with all the associated risks! if only it were passively managed.
The components of the equity/FI indices are actively managed.

The component nations of the world are also, actively managed. The aggregate of the nations is the index, and can be passively managed/held.
Indices wrote:That is the same as saying I am guaranteed higher returns with stocks. If that were the case then everyone would be a buy and hold investor.
It is not "the same" since the favored approach is the policy portfolio aka the Boglehead diversiifed, re-balanced-with-discipline collection of asset classes. That is all that is claimed. It is not buy-and-hold stocks, which is what is getting you into this view.
afan wrote:I think we need to read the entire papers, not just a few sentences excerpted from them. There is abundant evidence that risk correlates with return. F&F's point is that adding size and value to the regression eliminates any RESIDUAL correlation between risk and return.

They are not saying that there is no relationship between beta and return in a univariate regression. They are saying that size and value explain all the predictable return in 3-factor (beta, size, value) regression. Very different claim than "no correlation between risk and return"
+1
Dandy wrote:Now when you get to equities the level of risk is much harder to determine
In other words if Flakenstein knew how to measure the the risk he might find it, but he doesn't so the best you can hope for is "to be determined." And it is awfully hard.

pkcrafter
Posts: 13095
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Post by pkcrafter » Sat Sep 03, 2011 12:25 pm

Indices wrote:
Most people invest because they think they can make a quick buck or get rich.
You do not understand John Bogle's definition of investing. Don't confuse behavioral mistakes with Boglehead philosopy.
If there was an equity risk premium, why are investors so stupid and not buying up something that is guaranteed to have a higher expected return? Why are they buying bonds? Because they think they can get a better short term deal.
Where do you get the idea that an expected premium is guaranteed? It's not an equity premium, it's an equity risk premium.
No one says, "oh I know that I have a higher expected return with this asset class". That is the same as saying I am guaranteed higher returns with stocks.
It is?
I think most people assume we will 9.5 per cent annual average returns going forward.
I don't believe this is true.
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

Alex Frakt
Founder
Posts: 10853
Joined: Fri Feb 23, 2007 1:06 pm
Location: Chicago
Contact:

Post by Alex Frakt » Sat Sep 03, 2011 12:26 pm

Indices wrote:
Alex Frakt wrote:
Indices wrote:Where is the equity risk premium in Japan for the past twenty years and counting? Or the US for the past 11 years and counting?
Neatly illustrating recency bias - the behavioral tendency to overweight the importance of recent events.

You don't need advanced math to understand risk premia. The basis of any investment is an understanding of the likely return and the risks involved in achieving them. The lower the latter, the lower the price you should be willing to pay. Index investing obscures this, but even index investments are based on the collective judgement of others who have made this calculation.
But Alex, using 75 years of data is also recency bias. I could point to 60 years of data from the early 19th century where stock and bond returns were identical. The vast majority of investors do not think like you do. They all use recency bias to make stock picks or buy stocks at all. No one says, "oh I know that I have a higher expected return with this asset class". That is the same as saying I am guaranteed higher returns with stocks. If that were the case then everyone would be a buy and hold investor.
Cherry picking periods tells you nothing about expected returns or return premiums. You strive to eliminate bias by looking at results over the longest time periods available and at as many different data sets as possible. No one who has done this questions that there is the equity premium predicted by common sense. But it's also just as clearly a premium for risk, the higher risk asset classes have extremely variable returns and can be negative for long periods of time. But that is to be expected, if the risk didn't show up from time to time, there would be no basis for the premium.

Re- irrational traders. Since the premiums are there in the big view, we know that irrational traders are not the ultimate drivers of the market. But even in the short term of one investing lifetime, irrational traders are not going to hurt you - if you can avoid joining them.

If we accept that there is a set of irrational traders, there are only two possible outcomes from their trades. Either the noisy (irrational) traders cancel each other out or they don't. If they do, then they offset each others actions and have no net effect on the rational (fundamental) traders. If they don't cancel each other out (i.e., in aggregate they overprice or underprice an asset class), they will leave an exploitable advantage for rational traders, which can include us.

IMO, there certainly are irrational traders. I also believe they largely cancel each other out. But IMO enough of them remain to allow those of us with allocations diversified over multiple asset classes to take advantage through rebalancing. We all agree that rebalancing is a risk management activity, but to the extent that noisy traders push asset class valuations away from their "real" value, it is also a way for us to automatically perform asset class valuations, allowing us to sell high and buy low.

So, I agree with you to the extent that I would not recommend putting 100% of one's retirement into an single equity asset class, even TSM. But I would also not recommend the only logical outcome of your claimed belief that there is no such thing as a risk premium, which is to put 100% into short-term treasuries, CDs or savings accounts. Instead I recommend a mixture of stocks and bonds, and dividing the stocks into multiple asset classes, domestic and foreign, small and large, value and blend. And then rebalancing through some consistent scheme.

User avatar
Opponent Process
Posts: 5157
Joined: Tue Sep 18, 2007 9:19 pm

Post by Opponent Process » Sat Sep 03, 2011 12:59 pm

VennData wrote:
Opponent Process wrote:...like it or not history is actively managed, with all the associated risks! if only it were passively managed.
The components of the equity/FI indices are actively managed.

The component nations of the world are also, actively managed. The aggregate of the nations is the index, and can be passively managed/held.
I agree that financial assets can and probably should be passively held, in hopes of getting the best possible outcome, but the determinants of their return are definitely not passive. return is determined by many more variables than what some financial academic may try to distill down to common sense. world history has been, if anything, repeated patterns of a lack of common sense, although the most recent victors will always see their victorious data patterns as very sensical. humans always try to see patterns where there are none. risk is the evidence that there are no patterns.
30/30/20/20 | US/International/Bonds/TIPS | Average Age=37

TheEternalVortex
Posts: 2548
Joined: Tue Feb 27, 2007 9:17 pm
Location: San Jose, CA

Post by TheEternalVortex » Sat Sep 03, 2011 1:23 pm

I agree with the posters above that point out that there could certainly be a nonlinear relationship between risk and return. Since essentially all relationships are nonlinear, what's the point of this debate?

User avatar
dnaumov
Posts: 495
Joined: Tue Jul 27, 2010 6:04 pm
Location: Finland
Contact:

Post by dnaumov » Sat Sep 03, 2011 1:23 pm

Indices wrote:Where is the equity risk premium in Japan for the past twenty years and counting? Or the US for the past 11 years and counting?
You are not guaranteed a payout every year or even every decade.

1) Look at the crazy runup in equity valutations in US 1980-2000 and Japan 1970-1990, this is the payout.
2) And then the risk actually showed up.

allsop
Posts: 1046
Joined: Sun Jun 15, 2008 7:08 am

Post by allsop » Sat Sep 03, 2011 2:23 pm

I just got this (hypothetical) offer of a guaranteed 12% for the rest of my life with 0.0 risk. Should I take it? :D

Actually, a promise of high return with low risk is a good sign of fraud, and various "regulatory" writes so as well on their home pages.

User avatar
Opponent Process
Posts: 5157
Joined: Tue Sep 18, 2007 9:19 pm

Post by Opponent Process » Sat Sep 03, 2011 2:32 pm

allsop wrote:a promise of high return with low risk is a good sign of fraud
a promise of high return with high risk could also be a sign of fraud. the point is, no one can predict the future. risk does not guarantee return.
30/30/20/20 | US/International/Bonds/TIPS | Average Age=37

yobria
Posts: 5978
Joined: Mon Feb 19, 2007 11:58 pm
Location: SF CA USA

Post by yobria » Sat Sep 03, 2011 2:38 pm

allsop wrote:I just got this (hypothetical) offer of a guaranteed 12% for the rest of my life with 0.0 risk. Should I take it? :D

Actually, a promise of high return with low risk is a good sign of fraud, and various "regulatory" writes so as well on their home pages.
Or more likely, the risk is there, you just don't see it (see AAA rated MBS a few years ago).

Nick

User avatar
Lbill
Posts: 4997
Joined: Thu Mar 13, 2008 11:25 pm
Location: Somewhere between Up and Down

Post by Lbill » Sat Sep 03, 2011 2:39 pm

I've pieced together some of the author's commentary, which I find to be a fascinating refutation of the risk -> returns perspective, which was baptized with the CAPM, which is no longer well-accepted:
The front page of the New York Times financial section heralded the seminal article [by James H. Lorie and Lawrence Fisher, 1964] in the Journal of Business [that] reported the average of the rates of return on common stocks listed on the NYSE was 9 percent.

But, as this was within only 35 years of the Great Depression, it was rather shocking to learn that stocks, which were considered incredibly risky investments, had over a long period of time, a seemingly robust return premium over simply investing in bonds. The result was extremely useful, both to stockbrokers, because it justified greater equity investment, and researchers, because it was consistent with the new risk-begets-return theory of the CAPM.

Sharpe (1966) published the first empirical test of the CAPM. He examined 34 mutual funds over 10 years, using annual returns [finding that returns were a positive function of beta, or b] where a is the riskless return, and b presumably the price of risk. He found a=1.038, and b=0.836, consistent with the CAPM. Richard West (1968) noted that this test was almost meaningless. After all, if the test used the data from 1926 to 1935, b would have been negative if the CAPM held.

The debate changed dramatically when Fama and French published their paper in 1992. The key finding was not so much showing value and size generate large returns in the U.S. data, it was in showing that whatever success beta had, it was completely explained by the size effect. "Our tests do not support the central production of the [CAPM], that average stock returns are positively related to beta."

The market factor [beta], which Fama and French admit is not relevant for distinguishing within equities, is [only] necessary [in order to] to distinguish between equities as a whole and bonds.

In the end, we have atheoretical risk factors, each of which was chosen to solve a parochial problem recursively, so that return is a function of risk, which is a function of return, and so on.
As the author observes, it's rather curious that - even though the core assumption that equity risk [beta, or relative volatility] is related to returns has been supplanted by other explanatory factors such as size, value, and momentum, there is no commonly accepted understanding about how these factors are related to "risk" - only endless ex-post-facto debate and speculation. Thus there's no coherent theory incorporating the concept of "risk" that explains anything about equity returns.
"Life can only be understood backward; but it must be lived forward." ~ Søren Kierkegaard | | "You can't connect the dots looking forward; but only by looking backwards." ~ Steve Jobs

Indices
Posts: 1031
Joined: Sun Sep 27, 2009 11:40 am
Contact:

Post by Indices » Sat Sep 03, 2011 2:46 pm

Alex Frakt wrote: So, I agree with you to the extent that I would not recommend putting 100% of one's retirement into an single equity asset class, even TSM. But I would also not recommend the only logical outcome of your claimed belief that there is no such thing as a risk premium, which is to put 100% into short-term treasuries, CDs or savings accounts. Instead I recommend a mixture of stocks and bonds, and dividing the stocks into multiple asset classes, domestic and foreign, small and large, value and blend. And then rebalancing through some consistent scheme.
I never said because there is no risk premium that the only alternative are CDs or treasuries etc. I simply said that a risk premium is not the reason to buy stocks. The reason most people buy stocks is because of an irrational belief of quick money.

The reason I personally buy stocks is because they do well in times of economic growth. I hold stocks. I do not know if/when there will be another time period of prosperity. Which is why I also hold treasuries and gold.

Look at this way. Say is 1959 in Cuba. The Havana stock exchange averages 4 per cent returns per year. Should I expect that going forward? Obviously if I did I would have been wrong since Castro shut down the exchange permanently in 1960. Or what about 1994 Shanghai? In 1995 the market opens. What returns should I expect in 1995 Shanghai exchange? There's nothing to base it on.

What if the first year of returns in the Shanghai exchange (hypothetically) is 25 per cent positive. Should I expect that going forward? You can cherry pick any period of time to make a future prediction. Who is to say that the 20th century is not the anomaly? If you take 19th century returns into account it is. Is the fact that the Eastern Bloc did not have exchanges for decades mean that they would never have them forever? We now know that not to be the case, but in 1988 most people thought communism would go on forever. All trends end, including the one that says stock returns are greater than bond returns.

My point in saying all this is that the biggest problem with Boglehead philosophy is the overweighting of stocks based on past performance. It is a form of market timing. There is no evidence whatsoever, save for past performance, that states that equities will have higher returns than bonds. The theory of the equity risk premium is entirely based on past performance and the mistaken belief that people buy stocks because of a a vague understanding of risk. Ask the average investor why he/she is buying stocks and the word risk will never be mentioned.

User avatar
bob90245
Posts: 6511
Joined: Mon Feb 19, 2007 8:51 pm

Post by bob90245 » Sat Sep 03, 2011 3:41 pm

This question is addressed to Lbill, Indices and pwm112. You are in charge of your employer's 401(k) offerings. You are about to address the employees and are asked to recommend age-appropriate portfolios. These are for young people up to age 45, middle-aged people 46-59 and near retirees 60 and up. What are you recommending for these three groups?
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

Indices
Posts: 1031
Joined: Sun Sep 27, 2009 11:40 am
Contact:

Post by Indices » Sat Sep 03, 2011 3:43 pm

bob90245 wrote:This question is addressed to Lbill, Indices and pwm112. You are in charge of your employer's 401(k) offerings. You are about to address the employees and are asked to recommend age-appropriate portfolios. These are for young people up to age 45, middle-aged people 46-59 and near retirees 60 and up. What are you recommending for these three groups?
I would recommend 50 percent stocks in a low cost index fund and 50 per cent intermediate US treasury low cost bond fund. The age of the employees is irrelevant as the market doesn't respond to individual investors' ages. I would recommend rebalancing once per year to maintain that 50/50 balance. Any overweighting means a belief that one asset class will outperform the other in the future.

I personally use the Permanent Portfolio but there is so much hostility to gold and it is difficult to hold gold in a 401k that what I stated above would be the only politically acceptable choice for most.

User avatar
lmpmd
Posts: 735
Joined: Sun Jan 18, 2009 4:47 pm

Post by lmpmd » Sat Sep 03, 2011 4:48 pm

I think most (almost all) of us believe risk and reward are correlated in investing and probably in many other aspects of life. I'm not sure it can be proven in a prospective way. It's something that's probably woven into the laws of the universe. Just like probability is. We see evidence of it in investing and in others aspects of our life and we believe in it. I believe it's rationale to believe in it.

If you tell me the probability of heads is 50-50 in a coin toss, I could doubt you. And we could flip a coin a 1000 times. But if by some crazy chance it turns out heads 900 times it doesn't mean I'm right or the laws of probability don't hold. It means some bizarre chance event occurred or the experiment was flawed. I think it would be hard to prove prospectively that risk and reward are linked in investing and other areas of life. But experience says they are and I believe it.

Indices
Posts: 1031
Joined: Sun Sep 27, 2009 11:40 am
Contact:

Post by Indices » Sat Sep 03, 2011 5:07 pm

lmpmd wrote:I think most (almost all) of us believe risk and reward are correlated in investing and probably in many other aspects of life. I'm not sure it can be proven in a prospective way. It's something that's probably woven into the laws of the universe. Just like probability is. We see evidence of it in investing and in others aspects of our life and we believe in it. I believe it's rationale to believe in it.

If you tell me the probability of heads is 50-50 in a coin toss, I could doubt you. And we could flip a coin a 1000 times. But if by some crazy chance it turns out heads 900 times it doesn't mean I'm right or the laws of probability don't hold. It means some bizarre chance event occurred or the experiment was flawed. I think it would be hard to prove prospectively that risk and reward are linked in investing and other areas of life. But experience says they are and I believe it.
No one is saying stocks are not riskier than government bonds. Governments default only occasionally, stocks collapse all the time. What we are saying is the idea that there should be an expectation for greater rewards based on that risk. For the past 50 years I could trade a Cuban sovereign bond, but I cannot buy a Cuban market stock. Obviously Cuban bonds produced better returns than Cuban stocks as the Cuban stocks were so risky they aren't even in existence anymore. A company being taken over by the government is just another way it can disappear from a stock index.

VennData
Posts: 575
Joined: Mon Feb 26, 2007 5:52 pm

Post by VennData » Sat Sep 03, 2011 5:09 pm

Opponent Process wrote:world history has been, if anything, repeated patterns of a lack of common sense
There are many components to history, lack of common sense being just one, and difficult to isolate and measure. Also difficult in the extreme to declare it the overriding feature of human endeavour.
Opponent Process wrote:humans always try to see patterns where there are none.
Not always.
Alex Frakt wrote:Re- irrational traders. Since the premiums are there in the big view, we know that irrational traders are not the ultimate drivers of the market... If we accept that there is a set of irrational traders, there are only two possible outcomes from their trades. Either the noisy (irrational) traders cancel each other out or they don't. If they do, then they offset each others actions and have no net effect on the rational (fundamental) traders. If they don't cancel each other out (i.e., in aggregate they overprice or underprice an asset class), they will leave an exploitable advantage for rational traders, which can include us.

IMO, there certainly are irrational traders. I also believe they largely cancel each other out. But IMO enough of them remain to allow those of us with allocations diversified over multiple asset classes to take advantage through rebalancing. We all agree that rebalancing is a risk management activity, but to the extent that noisy traders push asset class valuations away from their "real" value, it is also a way for us to automatically perform asset class valuations, allowing us to sell high and buy low.
Excellent.

I would like to see Dr. Falkenstein use his conclusions about risk somehow in the marketplace.

zeugmite
Posts: 1053
Joined: Tue Jul 22, 2008 11:48 pm

Post by zeugmite » Sat Sep 03, 2011 5:21 pm

Whether particular assets or asset classes have a risk-return relationship or not, it's not at least logically impossible to have a risk premium (i.e. then "everybody would invest in it"), for the reason that not everybody has the same time horizon. In fact, the common formal measure of risk (variance) can just be reinterpreted as the time horizon over which the probability of failure to be within a certain band of the expected return falls below some threshold.

User avatar
Lbill
Posts: 4997
Joined: Thu Mar 13, 2008 11:25 pm
Location: Somewhere between Up and Down

Post by Lbill » Sat Sep 03, 2011 5:38 pm

This question is addressed to Lbill, Indices and pwm112. You are in charge of your employer's 401(k) offerings. You are about to address the employees and are asked to recommend age-appropriate portfolios. These are for young people up to age 45, middle-aged people 46-59 and near retirees 60 and up. What are you recommending for these three groups?
If you accept the premise of the author's paper, there is a weak or non-existent relationship between the riskiness of one's investment portfolio (viewed as volatility) and the geometric returns of the portfolio.
it is striking that a first approximation to risk via volatility or beta against the market return generates no positive risk premiums.
He offers the following observation, which would apply to individuals managing their own 401(k) plans as well:
As most government pensions in the US currently have significant equity risk premiums built in to their expectations, we should expect many will experience defaults and repudiations as these deviate more and more from their targeted, expected nominal values.
I guess anyone who feels the author's views have some validity can draw their own conclusions about how to manage their 401(k) plans - conservatively, I'd guess.
"Life can only be understood backward; but it must be lived forward." ~ Søren Kierkegaard | | "You can't connect the dots looking forward; but only by looking backwards." ~ Steve Jobs

allsop
Posts: 1046
Joined: Sun Jun 15, 2008 7:08 am

Post by allsop » Sat Sep 03, 2011 5:38 pm

yobria wrote:
allsop wrote:I just got this (hypothetical) offer of a guaranteed 12% for the rest of my life with 0.0 risk. Should I take it? :D

Actually, a promise of high return with low risk is a good sign of fraud, and various "regulatory" writes so as well on their home pages.
Or more likely, the risk is there, you just don't see it (see AAA rated MBS a few years ago).

Nick
Indeed!

Post Reply