What is the Equity Risk Premium, and Why is ‘Risk’ the Key Word?

Do you want to buy an investment that offers the prospect of delivering a bad return in bad economic times?

In most years the stock market outperforms the bond market. For example, here is a chart depicting the relative over and under performance of the S&P 500 U.S. stock index against 30-day U.S. Treasuries.

S&P 500 1964-2012

The blue columns indicate the magnitude of the excess return of stocks [(return of stocks) – (return of T-Bills)]; the red columns indicate the magnitude of stock underperformance. Stocks don’t win each and every year, but over time, stock investors have earned excellent returns. Economists call the extra stock reward the “Equity Risk Premium.” It is the extra reward investors receive for taking the risk of investing in stocks, rather than the risk-free return of, say, a bank certificate of deposit or a US Treasury Bill that matures only 13 weeks after it is issued. How big is the premium? During the fifty-year period from 1964, stocks beat T-Bills by 4.61% per year.

What is the source of this extra long-term reward? Does it really matter that stocks go up and down if the investor earns a higher long-term return by owning them? In fact, when looked at from a long-term perspective, are not stocks the truly safe investment because they deliver higher returns than bonds?

Look closely at the chart. Stocks performed poorly compared to safe T-Bills during years of general economic distress (the OPEC Oil embargo in 1973 – 1974, the Reagan Recession in 1982, the Bush Recession in 1991, the Tech-Stock Meltdown in 2000 – 2002; and the Global Recession in 2008). Stocks are risky because they deliver poor returns at exactly the worst time.

What is going on here? Stock brokers never suggest you should buy stocks because they are likely to perform poorly when the economy turns ugly. A bad return in bad times [BRBT] equals RISK. And risk is the source of the Equity Risk Premium! Without risk there can be no expectation of a return over and above the risk-free rate. Put another way, return is the reward investors expect to receive for taking greater risk.

Here is the non-technical explanation: You cannot get the big ‘ups’ without the big ‘downs.’ If you own stocks, you need the big ‘downs;’ and, if you are a long-horizon investor, you want the big ‘downs.’

Here is the technical explanation: The increase in downside volatility causes investors to demand a corresponding increase in compensation for investing in risky stocks. They demand an increase in the expected risk premium. The higher expected risk premium is implemented in the stock market by a reduction in current stock prices. However, lower current prices translate into higher expected future returns as volatility moderates and the economy recovers.

If you say “I want to sell my stocks because the losses terrify me,” then, at exactly the same time, you are also saying “I want to sell my stocks because I do not want the prospect of high future returns.” Of course, if you have to sell your total stock portfolio at a single moment in time, you cannot risk BRBT. In that case, you should not be in the stock market in the first place. However, if you can accept the risk, you have substantially increased your chance of a favorable outcome.

What about retired investors? Do not low or negative annual stock returns translate directly into lower future retirement income? This is a question with more moving parts, so we will tackle it in future essays. For now, however, suffice it to say that many retired investors are in an ideal position to welcome stock risk, because they have long-term time horizons and they require yearly liquidation of relatively small portions from their nest egg.

Bottom Line: When you buy stock, you are asking your investment to deliver a bad return at a bad time; and, this is exactly what you want to happen. Without risk there would be no reason to expect long-term compensation— the “extra” premium for holding stocks. Let the bad times roll!

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