Thursday, August 12, 2010

Equity Risk Premium: "Why the market’s rate of return—and your nest egg—may never recover"

Rob Arnott has done quite a bit of work in this area, from a practitioners perspective.
If the conclusion is correct the implications for the public sector union pension plans are staggering.
From The Atlantic:

The Great Stock Myth
In 1985, Rajnish Mehra and Edward C. Prescott, economists then at Columbia University and the University of Minnesota, published a paper pointing out a strange anomaly they dubbed “the equity premium puzzle.” Since the late 19th century, stock investments in America had generated returns that were 6 percent higher than what economists call “the risk-free rate—the yield on an investment for which there is virtually no risk of losing your principal. The low-risk investments, such as short-term U.S. government debt, had yielded less than 1 percent.Those “excess” stock-market returns, which include both price appreciation and dividends, are much higher than you would expect if they simply reflected the risk of losing your investment (don’t even get me started on the arcane procedures by which economists arrived at this conclusion). Moreover, this premium cannot simply be attributed to an underestimation of future corporate growth by investors. Even when expected dividend or corporate-earnings growth is taken into account, stock returns are higher than one would predict. 

Mehra and Prescott’s paper coincided with the early stages of a long boom in equities that lasted from 1982 to 2000. In the years after its publication, people like Wharton’s Jeremy Siegel (and many less careful or measured imitators) wrote books touting the benefits of long-term stock investing. Americans jumped into the stock market, first tentatively, then eagerly, and finally almost hysterically. Convinced that equities offered an attractive risk-reward ratio, they began bidding up the price of stocks. Stock-price increases fueled expectations of further growth, until by 1999, a Securities Industry Association survey showed that investors expected to earn an annual rate of return of 30 percent. In other words, they expected that by 2010, stock prices would have skyrocketed.
Their actual return, of course, has mostly been negative. Over the past decade, equity investing hasn’t offered much of a premium. The market went up (the Dow hit another record high in the middle of the decade). But then it went down again. In finance terminology, we experienced a lot of volatility—the major indexes have fluctuated a lot—but not much real growth.

One possible explanation for this pattern is that the equity premium has eroded. Markets have grown more efficient over time, as more and better information—and the computer tools to analyze it—has become available. Meanwhile, the stock market has democratized. Modern diversified portfolios have reduced some of the risk of holding stocks, because even if a few companies fail, they won’t take your entire nest egg with them. Rather, the failures average out with the successes to produce a relatively steady rate of return. As defined-benefit plans—what your grandfather called a pension—have died off, people have poured their retirement savings into mutual funds that offer this sort of diversification. The deeper pool of money flowing into equity markets means that equities no longer need to offer a higher yield in order to attract money from bond and other securities markets.

The equity premium’s shrinkage may have another reason. Financial markets have an interesting feature that has undone many a trading strategy: once everyone starts believing something, it often stops being true. If you discover an arbitrage opportunity—otherwise known as a “price anomaly” or “free money”—it will be profitable only as long as few people know about it. Once it is widely known, bidders will rush into the market until the discrepancy is traded away. After that happens, future returns will be lower....MORE