Is it possible that the skyrocketing stock market is in fact underpriced? Is the recent market turbulence just a tiny price that long-term stock-market investors pay to enjoy very large excess returns over bonds? Or, to put it another way, were investors whining during the recent downswing about the exact reason they get such spectacular long-term returns?
These possibilities are raised by an article in the latest Journal of Economic Perspectives, and by a gloss that contemporary history suggests be put upon it.
T he article, titled “The Equity Premium Puzzle,” asks a question that should strike joy in the hearts of stock-market investors. Why, ask noted finance experts Jeremy Siegel of Wharton and Richard Thaler of the University of Chicago, has the long-term rate of return for stocks consistently been so much higher than for fixed-yield assets? Over very long periods of time, the excess return of stocks over bonds yields staggering differences in profit.
For example: Ibbotson Associates, the finance-statistics firm, has found only one 20-year period, from late 1928 to late 1948, when the rate of return on Treasury bonds exceeded the return on the S&P 500, and that was by a small fraction of one percentage point. This period included many start points when pundits opined about the excessively high price of stocks. Another example that Thaler and Siegel use is particularly attention-getting: If you had bought $1,000 worth of Treasury bills in 1925 (because you were worried that the stock market was considered too high and too speculative), and held them until the end of 1995, you would have $12,720. But if you had put the thou into a broad portfolio of stocks, you would have $842,000. The difference comes from an average rate of return for the bills of 3.7 percent and for the stocks of 10.1 percent.
Finance experts call this difference in yields between stocks and bonds the “equity premium” or the “equity-risk premium.” It is the premium in the form of a lower rate of return that investors are willing to pay to own bonds or notes rather than stocks, supposedly because stocks are a great deal more dangerous. But what Siegel and Thaler ask–and what many of us investors have long asked–are two key questions: 1) Why is the risk premium as high as it is? 2) Why, for some investors, especially long-term holders, should there be any risk premium at all?
As to the first, Siegel and Thaler use a series of complex equations and models to find (as have other academics whom they cite) that the risk premium over the past two centuries has been almost insanely high. In fact, even for any 20-year period, the standard deviation of stock returns from the average return–i.e., the range within which two-thirds of all returns fall, used as a rough measure of volatility–is far smaller than would justify the immense premium investors give up to own bonds or bills with definite coupons and payment on maturity. Or, to put it another way, looked at from the perspective of time, stocks are simply nowhere near as risky as their rate of return compared with bonds would seem to indicate, at least so far in finance history.
The authors find, moreover, that this is a worldwide phenomenon. Even in nations where stock exchanges disappeared or were curtailed due to war or political catastrophe–such as Japan or Germany–returns to stocks exceeded returns to bonds over long periods.
Only when stock returns are considered on a year-to-year basis is there even a hint of enough risk in stocks to generate a risk-aversion premium such as exists. And even there, the fluctuations do not appear to compel as large a risk premium as exists, unless the aversion to risk is irrational.
But the second question is even more beguiling. Why should there be any risk premium at all for long-term investors if, on a consistent basis since the beginning of the 19th century, the returns to long-term stock-holding have been and are dramatically greater than to debt-holding? Why shouldn’t investors sell bonds and buy stocks to the point that bond prices are so low and stock prices so high that the returns on bonds over time approximate the return on stocks?
H ow long, Thaler and Siegel ask, will it take most investors to get wise to the fact that the equity premium is just too damned high? They assure the readers that they, like most economists and finance people, have their retirement savings in stocks. They say they know that over the next 20 years, if not for the next few years, they will be safe in predicting that stocks will outperform bonds no matter what the short-term turbulence. (Indeed, they point out, over 20-year periods, bond returns actually vary more widely than stock returns.)
And here, current history adds a major point. If all (or most) holdings were for only a year, one could see why stocks–which can fluctuate scarily in a year–might command a large risk premium. But if the composition of the market has changed considerably, so that it is now composed largely of baby boomers investing with a 20-year–or greater–horizon, might this not change the valuation of stocks, bid up their prices, and lower the equity premium? Especially now, when any investor can obtain almost perfect diversification with index funds and index options–and thus get the exact return of the market as a whole.
More immediately important, it puts the market’s recent, quickly overturned correction in quite a different light. All that volatility, upsetting as it may be for the short-term trader, is simply the small price stock investors pay for vastly superior long-term returns. If we didn’t have this kind of upsetting move occasionally, we would not get the risk premium at all, because then everyone would only want to hold stocks. Maybe we should stop worrying and learn to love this roller coaster, which has its dips but really does eventually climb to the sky–or at least has done so thus far.
