Classic Bernstein 12 — The Societal Risk Premium

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Classic Bernstein 12 — The Societal Risk Premium

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PREFACE: This is the twelfth (and last!) in a series of posts highlighting the classic investing insights of William Bernstein from the 1990s and early 2000s. Many new Bogleheads have never been exposed to his early writings — and while the data sets used may seem antiquated, his portfolio concepts and novel analyses are still helpful to investors today, new and old alike.

Previous topics in the series: 1-Asset Allocation & Time Horizon, 2-Choosing Portfolio Bond Duration, 3-Diversifying Portfolio Equities, 4-Stocks Always Beat Bonds?, 5-What’s a Thing Worth?, 6-The Value Premium & Inflation, 7-The Great Fund Fee Mystery, 8-Is Credit Risk Ever Worth Taking?, 9-The Stock Returns Fairy, Exposed, 10-Economic Growth and Stock Dilution, 11-Stocks, Economies and Populations
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In this final series post, we follow Mr. Bernstein through several centuries of historical financial data to uncover a fundamental truth about risk and return — which gives us, as 21st-century investors today, a perspective on our place in history.

The Risk-Free Rate. Living in the U.S. today, in what is likely the most secure political, social and economic environment ever seen on the planet, we take the existence of the "risk-free" rate — i.e., the time value of money sitting in a safe, 3-month Treasury bill — largely for granted. But this was not always the case. As Mr. Bernstein points out, our nation’s early political and financial prospects were far from certain. The global investor in 1790 would have been hard pressed to pick out the United States as an upcoming success story — and it’s history over the next century hardly inspired confidence, with an unstable banking structure, rampant speculation, and a civil war.

Even England’s political security has not been a sure thing during the past two centuries. Twice in this period, England’s very existence was threatened (during the Napoleonic War and early World War II). Looking at the data, Mr. Bernstein makes the observation that, historically, the cultural and political stability of a nation can be discerned in the level of its interest rates: the more advanced, secure and wealthier the nation, the lower the loan rate (charts below).
  • Image
    Source: William Bernstein, Efficient Frontier, 11/05 and 9/01
The Societal Risk Premium. Mr. Bernstein then extends this history of interest rates to include all rates of return — including the “risk-free” rate, the interest rates on less secure investments and, of course, equity returns. His essential point is that investment returns reflect the stability of a society. In highly uncertain societies and in precarious times, returns are higher, as there is less sense of public trust and of societal permanence. And vice-versa. As an example (my own, chart below), over the past ninety years, the earnings yield (inverse of P/E ratio and a proxy for real expected return) of the U.S. stock market has generally trended downward — reflecting the higher stock prices of a more stable, secure society. In short, the societal risk premium in the U.S. has decreased since the 1920s.
What lessons do Mr. Bernstein’s observations hold for investors today?
  • a) Investment returns reflect the inherent stability of a society. One of the prices we pay for our advanced standard-of-living is lower expected asset returns.

    b) The low stock prices that produce high future returns are not possible without catastrophe, uncertainty and hazard.

    c) If investors want the opportunity for high returns, they have to shoulder high risks. If they desire safety, they have to be content with more meager rewards.
Thoughts?
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Re: Classic Bernstein 12 — The Societal Risk Premium

Post by lgs88 »

:greedy Any yet I can't imagine many takers for a Somali index fund!

Interesting stuff. It's odd to think that what is good for a society over the long run is bad for returns.
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Re: Classic Bernstein 12 — The Societal Risk Premium

Post by Angst »

Simplegift wrote:over the past ninety years, the earnings yield (inverse of P/E ratio and a proxy for real expected return) of the U.S. stock market has generally trended downward — reflecting the higher stock prices of a more stable, secure society. In short, the societal risk premium in the U.S. has decreased since the 1920s.

Todd,
I've really enjoyed your series of posts, especially b/c I had not read so much of Bernstein's writing before. In this current post I'm inclined to question the significance of the trend line in your inverse P/E graph. I wish you could animate it such that we could watch the trend line change over time as blue data points accrue. Prior to 1987, it looks to me that the slope of the trend line would have fairly consistently been positive, even more so than it is negative today. And from the 1920's through the 1950's it looks like it would have been strongly positive. I'm not sure what this says. Did "we" finally mature or stabilize with the onset of the 1990's? As such, I'm inclined to think that the underlined portion of your statement above is a little bit strong.

Angie
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Re: Classic Bernstein 12 — The Societal Risk Premium

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Angst wrote:Did "we" finally mature or stabilize with the onset of the 1990's?
Good to hear you’ve enjoyed the series. I’ve learned a great deal from it myself!

For another perspective on your question: Jeremy Seigel also discusses the increased stability of the U.S. economy over time in his book, Stocks for the Long Run (4th ed.). He notes the more muted swings in real GDP growth since the 1800s, the shorter and milder recessions, and the longer economic expansions (chart below). He writes about the impact on stock valuations and equity premiums:
Jeremy Seigel wrote:Economists call this trend toward greater macroeconomic stability “The Great Moderation.” The moderation has been attributed to better monetary policy; a larger service sector, which is inherently more stable than the goods sector; and better inventory and production control, enabled in part by the information revolution.

Whatever the reasons, greater macroeconomic stability should lead to greater stability of earnings and a lower equity premium. The lower the equity premium, the higher will be the valuations of stocks relative to economic fundamentals, such as earnings and dividends.
So in this case, Mr. Bernstein and Mr. Siegel appear to have converged on the same point (i.e., the reduced societal risk premium in the U.S.), though coming at the issue from somewhat different angles.
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Re: Classic Bernstein 12 — The Societal Risk Premium

Post by qwertyjazz »

I really appreciate all the work you have done putting these together. I have learned a lot from them.
I think this particular point has to include Dr Bernstein made (I believe although I really do not want to misquote him especially as he may be reading this) that living in a low risk environment is probably a good thing. Investment returns are lower, but you probably have a higher chance of having money to invest. Your life is probably safer. It is probably a good trade off.
Thank you
QJ
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Re: Classic Bernstein 12 — The Societal Risk Premium

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Just to see if Mr. Siegel’s supposition has been true in the real world (i.e., greater societal stability leads to a lower equity risk premium), I’ve looked around for data on the realized equity premium for the U.S. market over the past century. The chart below is from the 2013 Barclays Equity Gilt Study, 1925-2012:
  • Image
    NOTE: Chart shows 10-year, realized equity risk premiums over bonds.
    Source: Seeking Alpha
Over the past 90 years, the realized results appear much as one might expect from a society that’s becoming increasingly more secure, stable and wealthy — a declining realized equity risk premium. However, it would sure be nice to have another century of data, before reaching any firm conclusions.
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Re: Classic Bernstein 12 — The Societal Risk Premium

Post by garlandwhizzer »

Simplegift wrote:

What lessons do Mr. Bernstein’s observations hold for investors today?

a) Investment returns reflect the inherent stability of a society. One of the prices we pay for our advanced standard-of-living is lower expected asset returns.

b) The low stock prices that produce high future returns are not possible without catastrophe, uncertainty and hazard.

c) If investors want the opportunity for high returns, they have to shoulder high risks. If they desire safety, they have to be content with more meager rewards.

Thoughts?
I think you summed it up quite well, Todd. Thanks for the post, insightful as usual.

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Re: Classic Bernstein 12 — The Societal Risk Premium

Post by Ari »

lgs88 wrote::greedy Any yet I can't imagine many takers for a Somali index fund!
Investing in Somali warlords would probably be quite lucrative, but very high risk.

Anyway, we might not be too keen on a Somali index fund, but a diversified Emerging Markets fund is a cornerstone in many a portfolio. I'm hoping to get some good returns from the societal risk premium.
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Re: Classic Bernstein 12 — The Societal Risk Premium

Post by nedsaid »

Thanks Todd for your great work here. I have read Bernstein's book, The Four Pillars of Investing. I also have read his posts here on the forum and have watched some of his interviews. His work is solid and so far has stood the test of time.

I do remember that Bernstein said that over very, very long periods of time that the returns of stocks and bonds are identical. I think this is because of the Societal Risk Premium and the fact that stock markets have gone bust in the past. Any comments on that?
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Re: Classic Bernstein 12 — The Societal Risk Premium

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nedsaid wrote:I do remember that Bernstein said that over very, very long periods of time that the returns of stocks and bonds are identical. I think this is because of the Societal Risk Premium and the fact that stock markets have gone bust in the past. Any comments on that?
Can’t say that I recall reading this in any of Mr. Bernstein’s writings. Though we have interest rate data going back centuries, the history of stock returns is much more restricted, to just the past 150 years or so and for just a few nations. Thus, even accounting for survivorship bias in the data, it would be difficult to determine the relative returns of stocks and bonds over very, very long periods. Perhaps there is a more theoretical consideration here that you recall?

We can say that during periods of tremendous social, political, and military strife, the prices of both stocks and bonds have historically declined precipitously. Sometimes this leads to high future returns, though at other times the losses can be permanent and even total. So the societal risk premium has historically impacted both stock and bond returns over the shorter term.
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Re: Classic Bernstein 12 — The Societal Risk Premium

Post by qwertyjazz »

Maybe you are talking about
http://www.efficientfrontier.com/ef/402/2cent.htm
19th vs 20 th century stocks vs bonds and inflation burst of standards change
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Re: Classic Bernstein 12 — The Societal Risk Premium

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Simplegift wrote:
nedsaid wrote:I do remember that Bernstein said that over very, very long periods of time that the returns of stocks and bonds are identical. I think this is because of the Societal Risk Premium and the fact that stock markets have gone bust in the past. Any comments on that?
Can’t say that I recall reading this in any of Mr. Bernstein’s writings. Though we have interest rate data going back centuries, the history of stock returns is much more restricted, to just the past 150 years or so and for just a few nations. Thus, even accounting for survivorship bias in the data, it would be difficult to determine the relative returns of stocks and bonds over very, very long periods. Perhaps there is a more theoretical consideration here that you recall?

We can say that during periods of tremendous social, political, and military strife, the prices of both stocks and bonds have historically declined precipitously. Sometimes this leads to high future returns, though at other times the losses can be permanent and even total. So the societal risk premium has historically impacted both stock and bond returns over the shorter term.
I have the book at home. I will see if I can locate the quote and cite chapter and page number. How about that?
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Re: Classic Bernstein 12 — The Societal Risk Premium

Post by ANC »

I think you have to add to this that some countries, like Japan and Germany, just like the stock market less.

Another fact I think worth looking at is the congruence between social development and institutional development, which Bernstein does discuss (perhaps a good topic for another post). I do find it hard to ignore the fact that the best 3 performing stock markets over the last 100 years--Australia, South Africa, and the US--are all common law countries. (Others point out that none of these 3 have had a war on their own territory since the Boer War).
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Re: Classic Bernstein 12 — The Societal Risk Premium

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Simplegift wrote:
nedsaid wrote:I do remember that Bernstein said that over very, very long periods of time that the returns of stocks and bonds are identical. I think this is because of the Societal Risk Premium and the fact that stock markets have gone bust in the past. Any comments on that?
Can’t say that I recall reading this in any of Mr. Bernstein’s writings. Though we have interest rate data going back centuries, the history of stock returns is much more restricted, to just the past 150 years or so and for just a few nations. Thus, even accounting for survivorship bias in the data, it would be difficult to determine the relative returns of stocks and bonds over very, very long periods. Perhaps there is a more theoretical consideration here that you recall?

We can say that during periods of tremendous social, political, and military strife, the prices of both stocks and bonds have historically declined precipitously. Sometimes this leads to high future returns, though at other times the losses can be permanent and even total. So the societal risk premium has historically impacted both stock and bond returns over the shorter term.
Okay, I found it. It is in the 2010 edition of The Four Pillars of Investing by Dr. Bill Bernstein. I found this in Chapter 1 titled "No Guts, No Glory." It is on page 7. Below is the quote:

"Two Nobel Prize-winning economists, Franco Modigliani and Merton Miller, realized more than four decades ago the aggregate cost of and return on capital, adjusted for risk, are the same, regardless of whether stocks or bonds are employed. In other words, had the ancients used stock issuance instead of debt to finance their businesses, the rate of return to investors would have been the same. So we are looking for a reasonable portrait of investment return over the millennia."

Further discussion from there indicates that from the experience of the Roman Empire, that the aggregate return on capital has a floor of about 4 percent. To me, this would imply that the rate of return on a balanced portfolio of stocks and bonds to be about 4 percent real.
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Re: Classic Bernstein 12 — The Societal Risk Premium

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nedsaid wrote:Further discussion from there indicates that from the experience of the Roman Empire, that the aggregate return on capital has a floor of about 4 percent. To me, this would imply that the rate of return on a balanced portfolio of stocks and bonds to be about 4 percent real.
Thanks, nedsaid. If a 4% real return has historically been considered a natural floor on the aggregate return on capital (when both stocks and bonds are considered), then I'd say the U.S. in 21st century appears to have outdone the Roman empire in terms of social, cultural and political stability. In other words, the expected real return of a 50/50 balanced portfolio in the U.S. today is only in the 2%-3% range — assuming a 4.5% expected real return for stocks and a 0.5% real return for bonds.

This indicates our societal risk premium in the U.S. today is likely lower than any other time or culture in human history.
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Re: Classic Bernstein 12 — The Societal Risk Premium

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Just to add: If interested in more background on the societal risk premium and similar topics, Mr. Bernstein went on in 2004 to write a very readable book of economic history, The Birth of Plenty: How the Prosperity of the Modern World Was Created — now available in both Kindle and paperback editions.

Though the book mainly explores the discontinuity in world economic growth around 1820 — i.e., the nonexistent global growth before this date, and the robust, sustained growth afterward — it does give the reader a wide perspective on why the societal risk premium has generally been declining worldwide over the last two centuries. From the book:
William Bernstein wrote:For the first time in human history, vast regions of the world are experiencing a continuous and dramatic increase in wealth and an accompanying improvement in living standards. The sources of this wealth — secure property rights, scientific rationalism, vigorous capital markets, and modern transportation and communication — have become so embedded in the Western way of life that they have easily survived the worst cataclysms of the last century — even in those Western nations that suffered the most physical damage.
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Re: Classic Bernstein 12 — The Societal Risk Premium

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The complete list of Simplegift's series is now in the wiki: Classic Bernstein
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Re: Classic Bernstein 12 — The Societal Risk Premium

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Simplegift wrote:As an example (my own, chart below), over the past ninety years, the earnings yield (inverse of P/E ratio and a proxy for real expected return) of the U.S. stock market has generally trended downward — reflecting the higher stock prices of a more stable, secure society. In short, the societal risk premium in the U.S. has decreased since the 1920s.
Here is a CAPE Yield variation of the chart posted in the OP, extended from 1871 to 2016 (using annual numbers from mult.com). Basically the same pattern, going from 8% to 6%.

Image

Now let me do a bit of cherry-picking. Here is the same chart, stopping in 1997 (not so long ago, a mere 20 years). Hm, funny, the downward trend totally disappeared. The societal risk premium isn't supposed to shift that drastically in a couple of decades, is it? One could rightfully suspect that the past 20 years might be more of a hiccup than a real trend shifter.

Image

I made a similar chart with the rolling 10yrs returns of the S&P 500 (a more direct indicator than the CAPE Yield), and cherry-picking a bit (stopping in 2007 instead of 2016), obtained a similar result.

My point isn't to disagree with Dr Bernstein's premise. I actually do suspect something like that will slowly unfold in the coming 50 years or so, and my AA reflects this belief (hedging my bets at 50/50 domestic/international, with a tilt towards emerging), but those trend lines are really easy to manipulate with a bit of cherry picking, hence can be rather misleading.
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Re: Classic Bernstein 12 — The Societal Risk Premium

Post by Angst »

siamond wrote:Here is a CAPE Yield variation of the chart posted in the OP, extended from 1871 to 2016 (using annual numbers from mult.com). Basically the same pattern, going from 8% to 6%.

Image

Now let me do a bit of cherry-picking. Here is the same chart, stopping in 1997 (not so long ago, a mere 20 years). Hm, funny, the downward trend totally disappeared. The societal risk premium isn't supposed to shift that drastically in a couple of decades, is it? One could rightfully suspect that the past 20 years might be more of a hiccup than a real trend shifter.

Image

I made a similar chart with the rolling 10yrs returns of the S&P 500 (a more direct indicator than the CAPE Yield), and cherry-picking a bit (stopping in 2007 instead of 2016), obtained a similar result.

My point isn't to disagree with Dr Bernstein's premise. I actually do suspect something like that will slowly unfold in the coming 50 years or so, and my AA reflects this belief (hedging my bets at 50/50 domestic/international, with a tilt towards emerging), but those trend lines are really easy to manipulate with a bit of cherry picking, hence can be rather misleading.
Thank you siamond - you've added an image to the thoughts I'd expressed earlier. The idea of "societal risk" evolving over time is interesting, but I'm inclined to doubt that there's nearly enough data to say a lot more than it's an interesting idea and we'll have to watch how things play out over the decades, if not centuries. Perhaps it's basic human nature to overestimate the durability of the societal progress we've made so far, whether it's today or 100 years ago, or the during republic of Rome.
Last edited by Angst on Mon Jul 04, 2016 10:29 am, edited 1 time in total.
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Re: Classic Bernstein 12 — The Societal Risk Premium

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qwertyjazz wrote:I really appreciate all the work you have done putting these together. I have learned a lot from them.
I think this particular point has to include Dr Bernstein made (I believe although I really do not want to misquote him especially as he may be reading this) that living in a low risk environment is probably a good thing. Investment returns are lower, but you probably have a higher chance of having money to invest. Your life is probably safer. It is probably a good trade off.
Thank you
QJ
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Re: Classic Bernstein 12 — The Societal Risk Premium

Post by Bill Bernstein »

Might as well chime in here.

1) Yes, the downsloping CAPE plot is not all that robust; as pointed out, take out the last 2 decades and the trend disappears. But you can look at it another way: has there ever been such a 20 year period in the past of high PEs? No.

2) You can summarize the reasons for decreasing equity returns as follows:

a) The supply/demand equation for caputal has changed in favor of the consumers: there's a lot more capital chasing relatively fewer opportunities. (If you doubt this, think about the supply/demand situation in a subsistence level society.)

b) People are living longer, so they're less impatient for consumption; as Irving Fisher pointed out, decreased impatience means decreased rates.

c) Thanks, in no small part to Jack, intermediation costs have fallen to near zero, making it easier for investors to access stocks and bonds. You no longer have to pay a broker several percent to assemble a portfolio, or even to clip the dividends. This also increases demand for securities, and so raises prices and lowers future returns.

But don't fret, the choice between antibiotics/cheap and safe travel/abundant and cheap food/and all of modern life's other goodies or a 500 BC standard of living with high investment returns is no choice at all.

Best,

Bill
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Re: Classic Bernstein 12 — The Societal Risk Premium

Post by nedsaid »

Thanks, Dr. Bernstein. It says a lot that your earlier works have held up over time. There has been new market history and new data since then. Your earlier works still look really good today and I am sure you have learned a lot since then. So it shows that your basic premises were very good back then.
At least you don't have to shudder when reading your earlier works, not everyone can say that.

Your writings have been very influential though I have known about you only in recent years. You and Larry Swedroe have both been strong recent influences.

Best wishes,

Ned
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