Are we certain there is an equity risk premium?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Topic Author
azanon
Posts: 3142
Joined: Mon Nov 07, 2011 9:34 am

Are we certain there is an equity risk premium?

Post by azanon »

I've noticed that in most all of the investment books I use as guides talk about an equity premium, and the interrelationship of risk and reward. Usually, arguments for the equity premium are based on historical US market data, and the 140 years or so of US data shows stocks trouncing bonds. Thus, the presumption is that stocks earn more because they're more risky. And the presumption is, no one would buy stocks if they weren't rewarded for the extra risk. And since there's 140 years of data of the US market, I guess there is a presumption that this is long enough to draw conclusions. What if that only seems long to us because 140 years exceeds our lifespan? Maybe we've seen an anomoly for 140 years and what we really need is 1,000 years of data?

But I got to thinking about this last night. I was reminded of all the timing models that I've seen that "definitely work" because when you back-test them, they provide superior performance. But the past doesn't necessarily equal the future. Or as a wise man said, correlation doesn't equal causation. So we bogleheads easily reject timing models because back-testing isn't enough. But it is apparently enough for the "risk premium"?

Then I thought a bit about popularity and success of casinos and lotteries. People spend millions of dollars a year just for the chance of making a lot of money in a short period of time, despite the fact that they would lose money long term. Well, you can make a lot of money in stocks in a short period of time too. So, if there's enough reason enough for people to "invest" their money in casinos, why would human nature be presumably different for stocks? In other words, why do we need the additional reason of an equity premium to invest in stocks, when simply the possibility of making money fast in casino is enough to compel plenty of irrational people to "invest" in lotteries and casinos. Perhaps we're really all just at a US casino and so far we're having a good night, but the house will eventually win?

I'm just bringing this up to make sure I'm not being naive about stocks. I'm hoping there is a much stronger argument for the equity premium than simply back-tested US stock vs. bond data. Please tell me there's much more!

* edited risk premium to read equity risk premium. Thanks Larry.
Last edited by azanon on Thu Jun 28, 2012 11:31 am, edited 2 times in total.
hsv_climber
Posts: 3971
Joined: Tue Sep 22, 2009 7:56 pm

Re: Are we certain there is an equity premium?

Post by hsv_climber »

Search the forum for the formula to calculate equity risk premium. It is a formula, that contains stock dividends, earnings growth, etc. It has nothing to do with back testing.
User avatar
tadamsmar
Posts: 9972
Joined: Mon May 07, 2007 12:33 pm

Re: Are we certain there is an equity premium?

Post by tadamsmar »

One thing that I think strenghtens the argument is that the back-testing for timing is often bogus because they leave out the transaction costs and taxes. Also, there are so many ways to time that it's more open to data-mining. So the equity premium is based on more solid back-testing.

The equity premium is also based somewhat on the notion that it is a risk premium. But the risk premium idea does not fall out of the data very neatly when tested on low vs high volatility stocks, so it's more of a theory based on logic than something backed up by observations.

I am not sure there is much more in favor of the notion.
Topic Author
azanon
Posts: 3142
Joined: Mon Nov 07, 2011 9:34 am

Re: Are we certain there is an equity premium?

Post by azanon »

hsv_climber wrote:Search the forum for the formula to calculate equity risk premium. It is a formula, that contains stock dividends, earnings growth, etc. It has nothing to do with back testing.
How is this any different than a market-timing formula that contains similar metrics and is "proven" to work when back-tested? I've read all of Dr. Bernstein's books, so I am quite familiar with the Gordon Equation. I'm not denying the existence of the equation any more than I am that various market-timing formulas exist.

I am a scientist by both profession and education, so I admit my demands for evidence can sometimes get intense.

Lets go ahead and dispel one dog that isn't going to hunt. I'm not the first to question this since my cursory searching around on google since I made the initial post yielded a huge write-up entitled "equity premium puzzle" on wiki. I'm sure there's tons of information on this. But I am curious what some of you think about this supposed puzzle.
staythecourse
Posts: 6993
Joined: Mon Jan 03, 2011 8:40 am

Re: Are we certain there is an equity premium?

Post by staythecourse »

I believe some guys ?Dimson and Marsh had a paper looking at different markets throughout the world. In EVERY market they looked at (as far as I remember) it showed equities besting government bonds from each country. Also keep in mind many government bonds in other countries are not considered as even risk free like U.S. bonds are so the ERP would likely be greater then what they found.

Now the argument definetly could be made that there is a survivorship bias since you are looking at only markets that have survived. That is why if your going to be an equity investor to diversify across different countries, currencies, and politics.

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle
hsv_climber
Posts: 3971
Joined: Tue Sep 22, 2009 7:56 pm

Re: Are we certain there is an equity premium?

Post by hsv_climber »

Equity risk premium is the excess return that an individual stock or the overall stock market provides over a risk-free rate. So, if the dividend yield is 5% (making the number up), and 10 year Treasury yield is 2% then equity risk premium is at least 3%. I am ignoring inflation & earning growth for simplicity,
I don't need to use back-testing & historic data for that.

Am I guaranteed to get 3% premium (above case)? Absolutely not, since stocks can cut dividends. And that is where the "risk" part comes in and nobody can quantify that. That is why you only need to take as much risk as you are willing to handle with your portfolio.
Last edited by hsv_climber on Wed Jun 27, 2012 3:42 pm, edited 2 times in total.
Rodc
Posts: 13601
Joined: Tue Jun 26, 2007 9:46 am

Re: Are we certain there is an equity premium?

Post by Rodc »

Different questions

1) Is it reasonable to expect an equity risk premium? (expected in the sense that a statistics book talks about expected values)
2) Can we model the expected risk premium? (for example Gordon Equation)
3) Can we estimate the risk premium from historical data?
4) Will I get a risk premium over the next X years?

I think it is entirely justified to expect (in a statistical sense) a positive risk premium.

Can we model it? Not likely very well. The Gordon equation just pushes using historical data down one level, but is hardly a fundamental model from first principles and does not work very well as far as I can tell.

Can we estimate it from historical data? Only in the very loosest terms. It has varied greatly over time and over which country you look at, and rarely are data from markets that completely collapsed included.

Will you get a positive risk premium over the next 5, 10, 20 years? Well depends on what level of risk shows up!
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
Topic Author
azanon
Posts: 3142
Joined: Mon Nov 07, 2011 9:34 am

Re: Are we certain there is an equity premium?

Post by azanon »

staythecourse wrote:Now the argument definetly could be made that there is a survivorship bias since you are looking at only markets that have survived. That is why if your going to be an equity investor to diversify across different countries, currencies, and politics.
But it wouldn't take too many market collapses to eat up every bit of the "equity premium" of the surviving markets. And if what I just said is true, then diversifying across many countries would just end up further ensuring that you end up with no equity risk premium since, odds are, you'd buy into one or two collapsing markets.

I don't know what the actual numbers are though if you included collapsed markets. But, again, I would intuitively think it wouldn't take all that much to eat up a modest equity risk premium of the survivors.
Topic Author
azanon
Posts: 3142
Joined: Mon Nov 07, 2011 9:34 am

Re: Are we certain there is an equity premium?

Post by azanon »

Rodc wrote:Different questions

1) Is it reasonable to expect an equity risk premium? (expected in the sense that a statistics book talks about expected values)
2) Can we model the expected risk premium? (for example Gordon Equation)
3) Can we estimate the risk premium from historical data?
4) Will I get a risk premium over the next X years?

I think it is entirely justified to expect (in a statistical sense) a positive risk premium.
I would be satisfied enough if the answer to #1 was yes. Sure, i realize in a real-world statistical dataset, the end result is not necessarily the expected result. I could flip a coin 4 times and end up with 4 tails, but I would have been in error to have expected that outcome from the beginning. As they say, sometimes s*** happens.

I just want to make sure that we're not dupes from the beginning. I was just wondering that, in the finance world, is there a wide-spread consensus that there exists an equity risk premium over an infinite time period for a given financial market. And now that we're talking about failed markets, is the premium still greater than 0 if you included all failed markets.
steve_14
Posts: 1507
Joined: Wed Jun 20, 2012 12:05 am

Re: Are we certain there is an equity premium?

Post by steve_14 »

Nothing is certain in investing. But common sense tells you a rational investor will demand a higher return for a higher risk investment, and the historical data backs that up (though you should never rely on historical data alone).
User avatar
GregLee
Posts: 1748
Joined: Wed Oct 27, 2010 3:54 pm
Location: Waimanalo, HI

Re: Are we certain there is an equity premium?

Post by GregLee »

azanon wrote:I am a scientist by both profession and education, so I admit my demands for evidence can sometimes get intense.
Then I would have expected you to be asking whether the equity premium is positive.
Greg, retired 8/10.
User avatar
LH
Posts: 5490
Joined: Wed Mar 14, 2007 2:54 am

Re: Are we certain there is an equity premium?

Post by LH »

No.

That is what real risk is.
Lumpr
Posts: 360
Joined: Tue May 19, 2009 2:23 pm

Re: Are we certain there is an equity premium?

Post by Lumpr »

azanon wrote:
Rodc wrote:Different questions

1) Is it reasonable to expect an equity risk premium? (expected in the sense that a statistics book talks about expected values)
2) Can we model the expected risk premium? (for example Gordon Equation)
3) Can we estimate the risk premium from historical data?
4) Will I get a risk premium over the next X years?

I think it is entirely justified to expect (in a statistical sense) a positive risk premium.
I would be satisfied enough if the answer to #1 was yes. Sure, i realize in a real-world statistical dataset, the end result is not necessarily the expected result. I could flip a coin 4 times and end up with 4 tails, but I would have been in error to have expected that outcome from the beginning. As they say, sometimes s*** happens.
If you don't think the answer to #1 is yes, please PM me for an invite to poker games.

In all seriousness, and if you're looking for scientific rigor google "equity premium puzzle" there has been a significant amount of academic research in this regard.
I just want to make sure that we're not dupes from the beginning. I was just wondering that, in the finance world, is there a wide-spread consensus that there exists an equity risk premium over an infinite time period for a given financial market. And now that we're talking about failed markets, is the premium still greater than 0 if you included all failed markets.
In markets that completely failed, I suspect a number of risk free assets had negative returns as well (pre-revolution russian bonds?). It would be interesting to see the data on the correlation of financial market failures and soveriegn default (including by way of revaluation, etc.).

That said, if there is no equity premium, then the EMH is . . .
Topic Author
azanon
Posts: 3142
Joined: Mon Nov 07, 2011 9:34 am

Re: Are we certain there is an equity premium?

Post by azanon »

Lumpr wrote:If you don't think the answer to #1 is yes, please PM me for an invite to poker games.
By think, do you mean "believe"? I mentioned I was a scientist earlier. From that perspective, there are two categories 1. What is known and 2. What is not yet known. If it was either #1 or #2, I'd be confused as to why there is even a page on the equity premium puzzle at wiki. I could tell you what I think, or believe, but if you were rational you wouldn't care unless it was followed by evidence.

As for poker, I'm sure you enjoy playing. As I stated earlier, just the chance of hitting it big is enough reason for most people to want to play. An equity premium is optional for the typical human, which is the reason for my concern. The often quoted statement people wouldn't invest in stocks if there wasn't an equity premium is patently false because I have been in a casino and personally witnessed several people playing.
User avatar
bottlecap
Posts: 6906
Joined: Tue Mar 06, 2007 10:21 pm
Location: Tennessee

Re: Are we certain there is an equity premium?

Post by bottlecap »

The answer is we have every reason to believe there is, but that doesn't guarantee you anything.

The notion is not based on the data. You have that backwards. The notion is based on theory and backed up by data. You can guess at the amount of the premium based on the data and be wrong. But the existence makes complete sense in theory and the data supports the theory.

JT
MathWizard
Posts: 6542
Joined: Tue Jul 26, 2011 1:35 pm

Re: Are we certain there is an equity premium?

Post by MathWizard »

A company can raise money by putting out bonds or by issuing stock.

Bondholders stand ahead of stock holders if the company goes out of business.
If both are priced rationally, stocks need to return more than corporate bonds,
otherwise why not just buy corporate bonds. If that were the only risk, then
the equity premium would be based on prob( (bonds don't default) and (stocks go to zero) )
So the only question is, are things rationally priced?

How does one assess a rational price?
One way is a value approach. For companies that are stable (long-term money makers, big
barriers to entry for competitors, no big technological changes on the horizon) where you
assume that there will be little change in the companies revenue, you can look at
the P/E ratio. If you buy at $100 and the P/E ratio stays steady at 12.5, you
have an 8% ROI. Think utilities and long lasting major brand names.
(Neither Apple nor MS makes the cut in being long lasting.)
KyleAAA
Posts: 9497
Joined: Wed Jul 01, 2009 5:35 pm
Contact:

Re: Are we certain there is an equity premium?

Post by KyleAAA »

The fact that equity capital is more expensive for companies to raise than debt capital leads credence to the risk premium theory.
patrick
Posts: 2589
Joined: Fri Sep 04, 2009 3:39 am
Location: Mega-City One

Re: Are we certain there is an equity premium?

Post by patrick »

Suppose you wanted to estimate lottery returns. If you averaged the results of every lottery player you would get a good estimate for the future. If you looked at a backtested strategy that meant to buy particular numbers on particular days it could easily be bogus.

Likewise the equity premimum is the based on the aggregate result of all edquity investors and wso is as reliable as we can get from the data. On tghe other hand backtested timing looks at a subset chosen after the fact, and it is easy to pick a winning one in hindsight even if the return are random.
patrick
Posts: 2589
Joined: Fri Sep 04, 2009 3:39 am
Location: Mega-City One

Re: Are we certain there is an equity premium?

Post by patrick »

as mentioned the failed equity markets probably bhad bad bond results too. Also note that they were mostly smaall and so had little im0pact on the world index.

Finally consider just how big the global equity preimum has been and that it has lasted over a century. It would take quitge a huge loss to erase that. Even if th US, UK, and Japan went to 0 that would not be enough to erase the equity premium for the world index. A few smaller markets failing would be an even smaller impact.
TJSI
Posts: 401
Joined: Thu Jan 27, 2011 3:03 pm

Re: Are we certain there is an equity premium?

Post by TJSI »

Azanon, You seem to be saying that because you observe a lot of casino players in the market, that they are the market. Yes, there are plenty of people in the market for the short run but there are also those who invest for the long run and they choose at time to buy stocks when their expected return exceeds a safe investment like CDs or Treasury bonds. The existence of casino players does not rule out other types of investors.

Someone said: "In the short run, the market is a voting machine. In the long run it's a weighing machine." I think that sums it up.
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 7:28 am
Location: St Louis MO

Re: Are we certain there is an equity premium?

Post by larryswedroe »

Don't have time to read through whole thread but the answer is simple
First it's not the equity premium. It's the Equity RISK Premium (ERP)
Second, it's always positive (or should be, though there have been brief periods --bubbles-when it was not the case) in ex ante sense. We cannot know if it will always be true in ex post sense or there would be no risk

Larry
Lumpr
Posts: 360
Joined: Tue May 19, 2009 2:23 pm

Re: Are we certain there is an equity premium?

Post by Lumpr »

azanon wrote:
Lumpr wrote:If you don't think the answer to #1 is yes, please PM me for an invite to poker games.
By think, do you mean "believe"? I mentioned I was a scientist earlier. From that perspective, there are two categories 1. What is known and 2. What is not yet known. If it was either #1 or #2, I'd be confused as to why there is even a page on the equity premium puzzle at wiki. I could tell you what I think, or believe, but if you were rational you wouldn't care unless it was followed by evidence.

As for poker, I'm sure you enjoy playing. As I stated earlier, just the chance of hitting it big is enough reason for most people to want to play. An equity premium is optional for the typical human, which is the reason for my concern. The often quoted statement people wouldn't invest in stocks if there wasn't an equity premium is patently false because I have been in a casino and personally witnessed several people playing.
I didn’t use the word “believe,” but honestly, I don't care if you think it, know it, believe it, have faith in it, intuit it, etc. If I were to trade against you, it's perfectly rationale for me to consider what you believe and think despite the evidence you may (or may not) have.

Regardless of the epistemological implications, if you are not willing to answer #1 in the affirmative, I'd really like to play poker with you. Poker is not a lottery game and your unwillingness to answer #1 in the affirmative indicates you may make mistakes in pricing uncertainty.
Last edited by Lumpr on Wed Jun 27, 2012 8:50 pm, edited 1 time in total.
steve_14
Posts: 1507
Joined: Wed Jun 20, 2012 12:05 am

Re: Are we certain there is an equity premium?

Post by steve_14 »

KyleAAA wrote:The fact that equity capital is more expensive for companies to raise than debt capital leads credence to the risk premium theory.
Just curiously, how do you calculate such a thing? Thanks.
Harold
Posts: 3154
Joined: Sat Mar 03, 2007 6:50 pm
Location: San Francisco

Re: Are we certain there is an equity premium?

Post by Harold »

KyleAAA wrote:The fact that equity capital is more expensive for companies to raise than debt capital leads credence to the risk premium theory.
Could you elaborate on this?

I've long thought the fact that $100M in stocks are worth the same as $100M in bonds discredits the risk premium theory (at least discredits the notion that stocks can be reliably expected to outperform bonds over a sufficiently long period). This is the opposite conclusion to the one you are reaching.

That question aside, since common sense has been mentioned earlier in this thread as proof, I'll point out that all common sense suggests is that given a chance to outperform (possibly very handsomely) over an investing time horizon -- many investors are willing to take that chance.
dodonnell
Posts: 421
Joined: Wed Oct 29, 2008 6:48 pm

Re: Are we certain there is an equity premium?

Post by dodonnell »

azanon wrote:
staythecourse wrote:Now the argument definetly could be made that there is a survivorship bias since you are looking at only markets that have survived. That is why if your going to be an equity investor to diversify across different countries, currencies, and politics.
But it wouldn't take too many market collapses to eat up every bit of the "equity premium" of the surviving markets. And if what I just said is true, then diversifying across many countries would just end up further ensuring that you end up with no equity risk premium since, odds are, you'd buy into one or two collapsing markets.

I don't know what the actual numbers are though if you included collapsed markets. But, again, I would intuitively think it wouldn't take all that much to eat up a modest equity risk premium of the survivors.
Exactly right. In an extreme theoretical sense, using MPT. It would take just one market *or asset class" to "fail" to destroy your whole portfolio permanently. You would continuously re-balance into the declining asset class, selling all other asset classes to keep your percentage allocation to the failing asset class. As the price of your failing asset class approaches zero, so does the value of your overall portfolio.

Example:

Portfolio of 10 asset classes equally weighted at 10% each.
Continuous re-blancing (a la David Swensen and the Vanguard Balanced Fund) to keep portfolio allocation constant at 10% each.
As one asset class approaches failure (approaches zero), the portfolio value remains constant at 10x that asset value.
... or 10x = 10 * zero = zero

It is critical that portfolios do not contain asset classes that can fail.

Therefore, having independent allocations to individual countries is very risky.
steve_14
Posts: 1507
Joined: Wed Jun 20, 2012 12:05 am

Re: Are we certain there is an equity premium?

Post by steve_14 »

dodonnell wrote:Exactly right. In an extreme theoretical sense, using MPT. It would take just one market *or asset class" to "fail" to destroy your whole portfolio permanently. You would continuously re-balance into the declining asset class, selling all other asset classes to keep your percentage allocation to the failing asset class. As the price of your failing asset class approaches zero, so does the value of your overall portfolio.

Example:

Portfolio of 10 asset classes equally weighted at 10% each.
Continuous re-blancing (a la David Swensen and the Vanguard Balanced Fund) to keep portfolio allocation constant at 10% each.
As one asset class approaches failure (approaches zero), the portfolio value remains constant at 10x that asset value.
... or 10x = 10 * zero = zero

It is critical that portfolios do not contain asset classes that can fail.
I don't think that works. The maximum one could put into the failing asset class at a given time would be 10% of total wealth, not 100%.
dodonnell
Posts: 421
Joined: Wed Oct 29, 2008 6:48 pm

Re: Are we certain there is an equity premium?

Post by dodonnell »

steve_14 wrote:
dodonnell wrote:Exactly right. In an extreme theoretical sense, using MPT. It would take just one market *or asset class" to "fail" to destroy your whole portfolio permanently. You would continuously re-balance into the declining asset class, selling all other asset classes to keep your percentage allocation to the failing asset class. As the price of your failing asset class approaches zero, so does the value of your overall portfolio.

Example:

Portfolio of 10 asset classes equally weighted at 10% each.
Continuous re-blancing (a la David Swensen and the Vanguard Balanced Fund) to keep portfolio allocation constant at 10% each.
As one asset class approaches failure (approaches zero), the portfolio value remains constant at 10x that asset value.
... or 10x = 10 * zero = zero

It is critical that portfolios do not contain asset classes that can fail.
I don't think that works. The maximum one could put into the failing asset class at a given time would be 10% of total wealth, not 100%.
Right, the maximum on could put into the failing asset class each time the portfolio is rebalanced, approaches, 10%. Taken to the limit, the portfolio would be zero after a minimum of at least 10 re-balances. This extreme example i used assumes continuous rebalancing (think ... many re-balances intraday ... like the Yale endowment ... like Vanguard Balanced). I used an extreme example on purpose, just to make the point that MPT assumes and requires that no asset class ever fail.
steve_14
Posts: 1507
Joined: Wed Jun 20, 2012 12:05 am

Re: Are we certain there is an equity premium?

Post by steve_14 »

dodonnell wrote:
steve_14 wrote:
dodonnell wrote:Exactly right. In an extreme theoretical sense, using MPT. It would take just one market *or asset class" to "fail" to destroy your whole portfolio permanently. You would continuously re-balance into the declining asset class, selling all other asset classes to keep your percentage allocation to the failing asset class. As the price of your failing asset class approaches zero, so does the value of your overall portfolio.

Example:

Portfolio of 10 asset classes equally weighted at 10% each.
Continuous re-blancing (a la David Swensen and the Vanguard Balanced Fund) to keep portfolio allocation constant at 10% each.
As one asset class approaches failure (approaches zero), the portfolio value remains constant at 10x that asset value.
... or 10x = 10 * zero = zero

It is critical that portfolios do not contain asset classes that can fail.
I don't think that works. The maximum one could put into the failing asset class at a given time would be 10% of total wealth, not 100%.
Right, the maximum on could put into the failing asset class each time the portfolio is rebalanced, approaches, 10%. Taken to the limit, the portfolio would be zero after a minimum of at least 10 re-balances. This extreme example i used assumes continuous rebalancing (think ... many re-balances intraday ... like the Yale endowment ... like Vanguard Balanced). I used an extreme example on purpose, just to make the point that MPT assumes and requires that no asset class ever fail.
Again it could never quite go to zero, as that would involve a 100% allocation from the other 9 classes to the loser during any given rebalance. But your point is well taken - a steadily declining asset can bankrupt (almost) a portfolio. And that's why relying to much on your investments reverting to mean in dangerous. If things go the other way you're in trouble.
stlutz
Posts: 5585
Joined: Fri Jan 02, 2009 12:08 am

Re: Are we certain there is an equity premium?

Post by stlutz »

A few random notes--

--Keep in mind that the average historical return of an index like the S&P 500 is not the return that was earned by the typical investor. Once costs and adverse market timing (the tendency to buy high and sell low), the equity premium that is actually earned by investors is really rather small. If everyone invested like Bogleheads, the theoretical premium would probably shrink.

--Expected returns and actual returns are inversely related. When investors expect high returns (as in 1999), prices are bid up which causes future actual returns to be low. When investors expect low returns (March 2009), prices are low which causes future returns to be high.

--Comparing the cost of debt financing vs. equity financing really doesn't work because the payoffs for those making the decisions are so different. Financing via debt is preferred because it leverages the returns for the owners/managers. Financing by equity is bad from their perspective because it dilutes future returns. Equity issuance most frequently is a way for owners/managers to "cash in", either through stock-based executive compensation plans or via IPO.
User avatar
tadamsmar
Posts: 9972
Joined: Mon May 07, 2007 12:33 pm

Re: Are we certain there is an equity premium?

Post by tadamsmar »

azanon wrote:
staythecourse wrote:Now the argument definetly could be made that there is a survivorship bias since you are looking at only markets that have survived. That is why if your going to be an equity investor to diversify across different countries, currencies, and politics.
But it wouldn't take too many market collapses to eat up every bit of the "equity premium" of the surviving markets. And if what I just said is true, then diversifying across many countries would just end up further ensuring that you end up with no equity risk premium since, odds are, you'd buy into one or two collapsing markets.

I don't know what the actual numbers are though if you included collapsed markets. But, again, I would intuitively think it wouldn't take all that much to eat up a modest equity risk premium of the survivors.
One problem with including all collapsed markets is that the collapses were sometime accompanied by collapses in the nation's ownership relations, revolutions. That is, you would have lost all your investments and even properties that you did not consider investments, not just stocks. So, this is not always a measure of the relative risk of stocks.
richard
Posts: 7961
Joined: Tue Feb 20, 2007 2:38 pm
Contact:

Re: Are we certain there is an equity premium?

Post by richard »

Stocks are riskier than bonds. Bonds are a contractual obligation while stocks are just a residual interest. People wouldn't buy stocks unless they hoped to get a higher return.

Inherent in the notion of risk is that there are no guarantees. Stocks could easily do worse, perhaps much worse, over the very short term, the very long term or anything in between.

If stocks were as safe as bonds, they would return as much as bonds.

This is the forward looking equity risk premium. There's also the historic premium, which appears to support theory, but there's no guarantee history is a reliable guide to the future.

That's about it.
Topic Author
azanon
Posts: 3142
Joined: Mon Nov 07, 2011 9:34 am

Re: Are we certain there is an equity premium?

Post by azanon »

TJSI wrote:Azanon, You seem to be saying that because you observe a lot of casino players in the market, that they are the market. Yes, there are plenty of people in the market for the short run but there are also those who invest for the long run and they choose at time to buy stocks when their expected return exceeds a safe investment like CDs or Treasury bonds. The existence of casino players does not rule out other types of investors.

Someone said: "In the short run, the market is a voting machine. In the long run it's a weighing machine." I think that sums it up.
That's not exactly what I said. I was simply saying that plenty of people give millions to actual casinos and lotteries fully satisfied with only the probability of making a lot of money in a short period of time despite knowing that the average payouts are always below 100%. So my point was, if that's good enough for casinos and lotteries, then it stands to reason it would be good enough for stocks too.

Another actual real-world example - plenty of people "short" the market even though there's a negative long-term return for shorting.

I'm just saying people would still buy stocks even if the long-term return were zero or negative. The statement "People wouldn't buy stocks if there weren't an equity premium" is simply not true. If it was, lotteries and casinos would go out of business.
Topic Author
azanon
Posts: 3142
Joined: Mon Nov 07, 2011 9:34 am

Re: Are we certain there is an equity premium?

Post by azanon »

richard wrote:Stocks are riskier than bonds. Bonds are a contractual obligation while stocks are just a residual interest. People wouldn't buy stocks unless they hoped to get a higher return.

Inherent in the notion of risk is that there are no guarantees. Stocks could easily do worse, perhaps much worse, over the very short term, the very long term or anything in between.

If stocks were as safe as bonds, they would return as much as bonds.

This is the forward looking equity risk premium. There's also the historic premium, which appears to support theory, but there's no guarantee history is a reliable guide to the future.

That's about it.
"Hoping to get a higher return" is not analogous to an equity premium. Equity premium means that stocks, matter of fact, average a higher return than bonds over the long-term. It means that for your risk you get a greater return, given an infinite time period. It is the concept of the equity premium that I was questioning. Not the fact that stocks offer the potential to make a lot of money in a short time period. No one disputes that the latter is true.
richard
Posts: 7961
Joined: Tue Feb 20, 2007 2:38 pm
Contact:

Re: Are we certain there is an equity premium?

Post by richard »

azanon wrote:"Hoping to get a higher return" is not analogous to an equity premium. Equity premium means that stocks, matter of fact, average a higher return than bonds over the long-term. It means that for your risk you get a greater return, given an infinite time period. It is the concept of the equity premium that I was questioning. Not the fact that stocks offer the potential to make a lot of money in a short time period. No one disputes that the latter is true.
Here are some possible meanings of equity premium

1) Historical

2) Future, aka what people hope to get

3) Future, aka what people are guaranteed to get. This is not realistic, either from a theoretical or historical point of view. If you are guaranteed a higher return, over any specified time period, then you are not taking risk and should not expect a higher return. Also, note there is no way to check what will happen over an infinite time period.

Do you mean one of these? If not, what exactly do you mean?
staythecourse
Posts: 6993
Joined: Mon Jan 03, 2011 8:40 am

Re: Are we certain there is an equity premium?

Post by staythecourse »

Folks can spend all day arguing if there is an ERP, but in the end of the day when we are in sluggish returns for stocks (as we are now in the last 10 years) the same folks won't believe it no matter what one says.

Here is a question for the naysayers of ERP: DId you doubt the premium during the 1980's or 1990's?? The answer I am sure is a resounding NO.

These doubters are not doubting based on logic or data, but on FEAR. It is behavioral. That is the only answer of why folks doubt only when stocks are doing poorly.

Folks should not discount how powerful fear is. Folks were afraid of fallling off the face of the Earth at one point no matter how much some scientists believed the world was round. No different here.

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle
Rodc
Posts: 13601
Joined: Tue Jun 26, 2007 9:46 am

Re: Are we certain there is an equity premium?

Post by Rodc »

I am a scientist by both profession and education, so I admit my demands for evidence can sometimes get intense.
Then you should know there is no such thing as proof that a scientific hypothesis is true (outside of math and logic which are not sciences). Every hypothesis is one inconvenient not yet discovered fact away from being proven false (note such a fact may or may not exist, but you can't know).

More to the point: In chemistry, for example, a reaction between two atoms, or a handful of atoms is fundamentally probabilistic due to the quantum mechanical nature of such interactions. But if you do an experiment on say 6.0225 × 10^23 atoms the aggregate behavior is essentially deterministic. So you can at least approach finding things that can proven. For example put a bunch of H and O into a container 2 parts to 1 and add a spark and you get H2O and a bunch of energy out of the reaction, every time.

Economics is a soft science where generally there is no proof to the degree one gets in physics and chemistry (and you do not get real proof there either).

More like many legal trials, there is no proof, the best you can hope for is that the evidence is well weighted one way or the other, and you take your best shot.

The search for "proof" (or extremely high confidence) is misguided.
I mentioned I was a scientist earlier. From that perspective, there are two categories 1. What is known and 2. What is not yet known.
But not a mathematician. See http://en.wikipedia.org/wiki/G%C3%B6del ... s_theorems

While that applies to logic of arithmetic I think it applies more broadly: there are things that are true but are simply unknowable in a very fundamental sense.

In (virtually?) all areas of life you are forced to make decisions based on incomplete knowledge and understanding, investing is no different.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
Harold
Posts: 3154
Joined: Sat Mar 03, 2007 6:50 pm
Location: San Francisco

Re: Are we certain there is an equity premium?

Post by Harold »

richard wrote:
azanon wrote:"Hoping to get a higher return" is not analogous to an equity premium. Equity premium means that stocks, matter of fact, average a higher return than bonds over the long-term. It means that for your risk you get a greater return, given an infinite time period. It is the concept of the equity premium that I was questioning. Not the fact that stocks offer the potential to make a lot of money in a short time period. No one disputes that the latter is true.
Here are some possible meanings of equity premium

1) Historical

2) Future, aka what people hope to get

3) Future, aka what people are guaranteed to get. This is not realistic, either from a theoretical or historical point of view. If you are guaranteed a higher return, over any specified time period, then you are not taking risk and should not expect a higher return. Also, note there is no way to check what will happen over an infinite time period.

Do you mean one of these? If not, what exactly do you mean?
For most people the issue is that they will answer 2 and plan and act more in line with 3. The difference being that they will substitute the word expected for the word guaranteed.

We talk as if such a mathematical expectation were obvious (even common sense due to the additional risk being taken) -- but if there were a consensus that a premium could be expected, market pricing (and initial capitalization) should reflect that. It doesn't. $100K in stocks is worth the same as $100K in bonds. All of us stock investors are hoping for an equity risk premium to benefit us over our investing lifetimes, but hope may be the best we can do.
Verde
Posts: 349
Joined: Mon Dec 31, 2007 3:47 am
Location: South Africa

Re: Are we certain there is an equity premium?

Post by Verde »

azanon wrote:An equity premium is optional for the typical human.
This may well be true.

You may not have much respect for the ability of aggregate investors to make rational decisions, but perhaps you have more faith in the world’s corporate leaders who are expected to make smart decisions in return for their ample rewards .

They take the other side of the trade – their cost of capital = the return to investors.

If these executives thought that equity financing was cheaper than debt financing (ie. negative expected equity risk premium), they would simply raise sufficient equity to pay off all debt.
learning_head
Posts: 844
Joined: Sat Apr 10, 2010 6:02 pm

Re: Are we certain there is an equity premium?

Post by learning_head »

Interesting discussion... If you think of "risk" as "downside risk" / bad returns and with "premium" implying positive delta, perhaps a better term for ERP is "equity noise", where noise could be positive or negative...

I think OPs observation is correct that just because something is riskier, does not mean people will not overvalue it (examples of casinos seem good here). This also includes long periods of time of being overvalued (Japan?), and cases of completely failing markets. I also think OP agrees that we don't know for long periods of time whether the equity "noise" will be positive or negative. However I think OP's main question is whether there is something intrinsic that indicates that the equity noise should be positive / will be positive...

When you invest in some market (including a world market), you a buying (a piece of) ownership of it. So, I think OP's question is effectively should that piece of ownership intrinsically grow at greater pace than say corresponding bond investments? For as long as overall system of ownership does not collapse, my guess is yes, because a surviving company / market would want to borrow as lower rate than it can invest the proceeds at - else it would be self destructive...

(This is unlike casinos where expected noise value should be negative so casinos have profits.)
Last edited by learning_head on Thu Jun 28, 2012 10:06 am, edited 4 times in total.
Verde
Posts: 349
Joined: Mon Dec 31, 2007 3:47 am
Location: South Africa

Re: Are we certain there is an equity premium?

Post by Verde »

stlutz wrote:--Expected returns and actual returns are inversely related. When investors expect high returns (as in 1999), prices are bid up which causes future actual returns to be low. When investors expect low returns (March 2009), prices are low which causes future returns to be high.
This is not the view of mainstream finance.
Rather high prices (associated with lower than normal discount rates applied to expected future cash flows) reflects the market’s expectation of a lower risk associated with those cash flows.
So prospective returns are lower because risk was lower, or so the theory goes.

In 1999 (so the theory says) prices were high not because investors expected high future returns, but because investors believed that risk would be lower and therefore they demanded lower expected returns. To exacerbate the valuations at the time they also believed that growth would account for a larger proportion of those lower returns than was historically the case.

As it turned out the unexpected risk showed up - the growth did not.
Verde
Posts: 349
Joined: Mon Dec 31, 2007 3:47 am
Location: South Africa

Re: Are we certain there is an equity premium?

Post by Verde »

azanon wrote:"Hoping to get a higher return" is not analogous to an equity premium. Equity premium means that stocks, matter of fact, average a higher return than bonds over the long-term. It means that for your risk you get a greater return, given an infinite time period.
The expected equity risk premium is not guaranteed over any time period. Time does not lower risk.
The realised premium should not be confused with the expected premium. Expected premium = mean of distribution. Realised premium = 1 data point in distribution.

For any civilisation with a finite life expecatancy the ERP will be zero, as all value is destoyed in the end.
Topic Author
azanon
Posts: 3142
Joined: Mon Nov 07, 2011 9:34 am

Re: Are we certain there is an equity premium?

Post by azanon »

larryswedroe wrote:Don't have time to read through whole thread but the answer is simple
First it's not the equity premium. It's the Equity RISK Premium (ERP)
Second, it's always positive (or should be, though there have been brief periods --bubbles-when it was not the case) in ex ante sense. We cannot know if it will always be true in ex post sense or there would be no risk

Larry
My apologies on the first point. You are correct, and I am glad that you clarified the semantics issue, and I'll just say ERP from now on. If it's any consolation, I think most of the responders knew what I meant.

As for the second point, that was the intent of my post - to discuss the issue. Apparently it is at least worth discussing given the massive amount of content I've been able to find on the net.
User avatar
LH
Posts: 5490
Joined: Wed Mar 14, 2007 2:54 am

Re: Are we certain there is an equity premium?

Post by LH »

azanon wrote:
larryswedroe wrote:Don't have time to read through whole thread but the answer is simple
First it's not the equity premium. It's the Equity RISK Premium (ERP)
Second, it's always positive (or should be, though there have been brief periods --bubbles-when it was not the case) in ex ante sense. We cannot know if it will always be true in ex post sense or there would be no risk

Larry
My apologies on the first point. You are correct, and I am glad that you clarified the semantics issue, and I'll just say ERP from now on. If it's any consolation, I think most of the responders knew what I meant.

As for the second point, that was the intent of my post - to discuss the issue. Apparently it is at least worth discussing given the massive amount of content I've been able to find on the net.
In terms of "massive content" in regards to OP. Yeah, lots of "content" but

There really is almost zero meaningful evidence in regards to your question.

There is simply not enough data.

Implicit in the question, perhaps, would be "Are we certain there is an equity risk premium" in my financial lifetime (yeah positive assumed as well).

The answer is:

No.

That is what risk is. Its what in fact, the ERP is based on. The risk.

We ARE certain, that there is ER, equity risk. In a sense, we can be somewhat certain there is a "premium" positive, negative, zero (which trivializes your question with semantics)...... But no, we are not almost by definition certain there will be a POSITIVE, otherwise, the premium would not exist.

in your fincial lifetime there may be a "negative Equity premium"

To model this, is unfortunately statistically meaningless. If a financial lifetime is say 40 years meaningful accumulation/decumulation. Then the statistical N is ludicrously small...... Nowhere near enough independant samples.

Gordon equation, is not predictive in a meaningful financial sense. It will be used, but the inputs chosen, are more a Rorschach blot with behavoiral numbers applied.

For Gordon (what circa 1956 creation??), if its useful, well heck.... show me where it was used circa 1979-1981 "death of equities" time to predict the 80s 90s?????? What numbers were chosen back then as inputs? If we were omnipotent, and could see every applied use of the Gordon calculated back then, I bet they did not predict the boom on average, nowhere near. The chosen inputs were "wrong". The Gordon equation is a behavioral mirror. It shoots back what picture we put in front of it.

its nice for papers, nice for selling, maybe some actual planning use to make humans (advisors and clients) feel good, scientific, and stay the course, but has no ex ante predictive ability of the stock market return for a financial lifetime, above that of simply assuming the average return. The inputs used are somewhat arbitrarily chosen by definition, resulting in no predictive usefullness.

this all comes down to "risk" definition too.
YDNAL
Posts: 13774
Joined: Tue Apr 10, 2007 4:04 pm
Location: Biscayne Bay

Re: Are we certain there is an equity risk premium?

Post by YDNAL »

azanon wrote:Are we certain there is an equity risk premium?
Yes!

Is it guaranteed?*... no!

* we are guaranteed to pay taxes and to die.
Landy | Be yourself, everyone else is already taken -- Oscar Wilde
swaption
Posts: 1245
Joined: Tue Jul 29, 2008 11:48 am

Re: Are we certain there is an equity risk premium?

Post by swaption »

Ok, I am going to try to take a stab at this, in some level of detail to try to aid in understanding. Perhaps, having been both an engineer and now in finance for some time, I can speak both languages relevant to this discussion.

The Gordon Equation does not unto itself answer the question. Embedded in that are in fact knowns and unknowns. Let’s start with the knowns, which essentially boils down to a primer in accounting. There are all sorts of details and complications such as cash vs accrual accounting, economic vs accounting returns, etc. that one can briefly put aside for this consideration. Let’s start with an earnings yield of say 7%. From this earning yield the company (or index) pays a dividend of 2%. So what does this mean? Let’s say the company has total assets of $1,000, of which $200 is financed with equity (for these purposes I’ll exclude the differentiation between market and book value of equity). So the earnings for this company (or index) is 7% of $200, or $14. Of this $14, $4 gets paid out in dividends (that’s 2%) and the remaining $10 is retained. The company’s equity increases to $210 and assets increase to $1,010. To finish this piece of the process, one might assume the company maintains constant leverage at 80%, which means the company would borrow $40 more, bringing the assets up to $1,050. To finish out the knowns (along with some theoretical assumptions), the company assets and equity increase by 5%, which is exactly the same amount as the percentage of earnings that were retained.

Now for the portion of the equation that represents the unknowns. What does all of the above imply with respect to future earnings. The theory basically assumes that the above continues onward. The company earns 5% more the next year based on the assets and equity that are 5% larger than the year before, and this goes on each year. So basically you get a 2% dividend and earnings that grow 5% each year. The big assumption is that the 7% earnings yield is “normal” and that the money being reinvested can find similar investment opportunities. What Schiller would say is that the current level of earnings is not normal, and that the proper earnings level should be taken as a historical average over some period of time. In terms of reinvestment, one might not have any idea what the “market” assumptions are that are embedded in the price. Historically, there has been some “leakage” where earnings have not grown at the rate that they have been retained. These are the big unknowns that represent broad assumptions, for which variations can have a significant impact on the implied equity risk premium. It’s also impossible to know what the market assumptions are for these variables. My own opinion is that the world of equities is a bit simpler than the Schiller model. I’ll happily clip my 7% earnings coupon relative to current alternatives, as the arguments against this continuing are more complex than the arguments for it continuing.

The arguments regarding the pecking order of corporate capital are valid, but only to a point. Yes, equity is riskier and more expensive than debt from the corporate perspective, and hence the premium. But try having that discussion with an internet company in 1999. How much of a coupon do you want me to pay on that debt? No thank you, I think I’ll be raising equity. Corporations are much better at adjusting to Mr. Market than investors.

Briefly, with respect to the gambling analogies. As always, off base. The reason the equity risk premium exists is behavioral (although with a fundamental underpinning). Humans are by nature generally risk averse, which means they value being able to eat more than they do taking an extra vacation. This is behavioral, but also quite rational. This is why most would not bet their life savings if given 3:1 odds on a coin flip. This is also why there is a risk premium for equities. At various points in time, people can be more or less risk averse, which is going to determine the size of the risk premium. In the current adverse environment, not unlikely that there is greater uncertainty regarding basic consumption (food, shelter, etc.), leading to greater risk aversion, which could certainly be consistent with a higher risk premium. The opposite was likely true circa 2000. None of this applies to gambling. Gambling is a risk seeking activity, where the risk of loss (and gain) is the attraction. People do it for entertainment (the thrill), while hopefully not compromising their ability to feed themselves in the future. There certainly is a subset of the population that may be risk seeking by nature (i.e. they would take the 3:1 coin flip bet), but this is not the majority.
psteinx
Posts: 5785
Joined: Tue Mar 13, 2007 2:24 pm

Re: Are we certain there is an equity risk premium?

Post by psteinx »

Just wanted to commend rodc on his excellent post on the relative confidence of beliefs in math, chemistry and investing, and swaption on the post immediately above this one. Great posts.

As to the ERP, we can phrase the question in various, somewhat more precise ways, and get different answers. I think the somewhat simplified answer is that the evidence (of various sorts) is strong enough to convince ME that there is a positive ERP over investment horizons that are relevant to me (from say, 5 years up to perhaps 40-50 years out). Basically, I would reiterate swaption's argument (perhaps plugging in some current/recent data on yields, earnings and the like for equities and bonds), albeit with the caveats that rodc outlines about our limited confidence in such things, but the need to nonetheless take action even in the face of uncertainty (as we do in many walks of life - not only finance).

EDIT: And to be clear, the positive ERP that I speak of is the EXPECTED ERP. Realized equity returns, either relative to bonds or on an absolute basis or whatever, may be negative for many years out into the future, conceivably even over my entire multi-decade investing horizon.
Last edited by psteinx on Fri Jun 29, 2012 10:54 am, edited 1 time in total.
Bongleur
Posts: 2276
Joined: Fri Dec 03, 2010 9:36 am

Re: Are we certain there is an equity risk premium?

Post by Bongleur »

Hmmm... if it turns out that the ERP is NOT positive going forward... then our society as we have constructed it is doomed. It must be reconstructed so that wages alone can pay all expenses for a lifetime. So is it theoretically possible to manipulate/construct markets to keep the ERP positive?

Note: If a company's ERP is negative, then their bonds are no good either.
Seeking Iso-Elasticity. | Tax Loss Harvesting is an Asset Class. | A well-planned presentation creates a sense of urgency. If the prospect fails to act now, he will risk a loss of some sort.
swaption
Posts: 1245
Joined: Tue Jul 29, 2008 11:48 am

Re: Are we certain there is an equity risk premium?

Post by swaption »

psteinx wrote:Just wanted to commend rodc on his excellent post on the relative confidence of beliefs in math, chemistry and investing, and swaption on the post immediately above this one. Great posts.

As to the ERP, we can phrase the question in various, somewhat more precise ways, and get different answers. I think the somewhat simplified answer is that the evidence (of various sorts) is strong enough to convince ME that there is a positive ERP over investment horizons that are relevant to me (from say, 5 years up to perhaps 40-50 years out). Basically, I would reiterate swaptions argument (perhaps plugging in some current/recent data on yields, earnings and the like for equities and bonds), albeit with the caveats that rodc outlines about our limited confidence in such things, but the need to nonetheless take action even in the face of uncertainty (as we do in many walks of life - not only finance).

EDIT: And to be clear, the positive ERP that I speak of is the EXPECTED ERP. Realized equity returns, either relative to bonds or on an absolute basis or whatever, may be negative for many years out into the future, conceivably even over my entire multi-decade investing horizon.
Thank you psteinx. I guess it was a real conversation killer, the absence of which might have enabled the preferred mode of endless circular debate.

I think ultimately many here don't fully get the connection between the black box of index investing and the undelrying business fundamentals. For example, most people understand the economic implications of investing in a pizza restaurant. If you do the right anlayisis, then you know what return to expect and the equity risk premium is staring you in the face. If you are one of ten people investing in the restaurant, then perhaps you need to do less analysis to feel secure that your "price" of the investment provides some premium. Perhaps you are one of a thousand investors, and fifty of them really know a lot about restaurants, then you are likely even more confident about the price. But none of this will prevent you from the risk that you lose 100% of your investment over any time horizon.

Investing in an equity index is exactly the same thing as the pizza place above. Although the risk is greatly mitigated, it is not eliminated, over any time horizon. That is true regardless of the equity risk premium.
phonond
Posts: 9
Joined: Thu Jun 21, 2012 9:29 am

Re: Are we certain there is an equity risk premium?

Post by phonond »

I have a rather simple view of debt versus equity using the concept. On the downside both are the same as the lowest a portfolio will go is to 0 (i.e loss of investment) ignoring the cost of transacting). However, the upside of debt is bounded contractually while the upside of equity is theoretically limitless. Using a basic expected value calculation, the risk premium on equity should always be higher (though it might not reflect in the market for short bursts). Am I too simplistic?
Post Reply