Posted in Triplett & Carothers on June 2, 2023

Investors have a mystery to solve, as challenging as a tale by Dame Agatha Christie or Sir Arthur Conan Doyle: Why is it that returns from stocks have generally wildly outperformed those from bonds and other fixed income going back about a century?

The enigma has been thoroughly researched for almost 40 years, yet economists as a group have not come up with a universally accepted explanation. Standard theory states that the greater the risk of any investment, the higher the return should be for holding it. Yet the higher returns of stocks over bonds far exceed the actual difference in their riskiness. That is the conundrum.

Pieces of the puzzle

Risk and return are opposite sides of the same coin. The extra slice of return from equity investments over bonds is called the equity risk premium. Think of it as a carrot, serving to compensate investors for buying risker equities rather than super-safe bonds. Without that extra incentive, why would anyone put their funds into a more dubious prospect?

The equity risk premium constantly fluctuates according to factors such as inflation, interest rates and monetary policy but tends to average around 5%-6%. In early 2023, the equity risk premium stood at about 1.7%. The number is, of course, always fluctuating. Today, it remains on the low side compared with the long-term average rate of approximately 3.5% over the years.

So how do we adjust and update the equity risk premium using the S&P 500 to represent the whole market? There are four easy steps:

1. Take the projected earnings per share for the index.
2. Divide that number by the current S&P level.
3. Multiply your result by 100 to get a percentage.
4. Subtract the current risk-free rate.

Diverse risk-free instruments offer different yields, which result in different equity premiums. For the risk-free rate, we typically use 10-year government bonds, but we could also select Treasury bills or 5-year bonds. Whichever risk-free instrument you choose, the main point is that Uncle Sam is extraordinarily unlikely to default on its debts, so any government debt is theoretically the most secure obligation conceivable.

Meanwhile, equities have historically outperformed bonds, especially during periods when stocks are popular. Since 1972, 10-year Treasury bonds have returned about 7.2% compared with 10.5% for stocks. The 3.3% difference is the equity risk premium. Note that the equity risk premium is more pronounced in the U.S. than elsewhere. Results have been more mixed in Europe and Japan.

Explanations for the puzzle

Since Rajnish Mehra and Edward Prescott created the equity risk premium concept in 1985, fellow economists have been struggling to explain why the equity risk premium is so rich. Still, none of the following hypotheses fully account for the discrepancy:

• Rare events — investors require high premiums for protection against the possibility of catastrophic events like the World Wars, the Great Depression or the Global Financial Crisis.
• Loss aversion — investors are twice as sensitive to losses as gains.
• Tax distortions.
• Optimization — investors might not be seeking perfect solutions but settling for second best when limited information is available.
• Survivorship bias — many stock exchanges that were functioning in 1900 no longer exist, which distorts historical calculations for the equity risk premium.
• Statistical illusion — returns depend on the chosen time frame.

Projections also play a part. Analysts must construct future estimates for returns from past performance. For instance, in early 2023, consensus earnings predicted about $230 per share and 5% earnings growth, for corporate earnings estimates for the S&P 500 Index. But those forecasts may not be taking into account tighter monetary policy and may therefore turn out to be overly optimistic.

Your unique risk tolerance

Even if you know nothing specific about a particular investment’s riskiness, a glance at the equity risk premium may give you a clue.

Equity risk premiums can also help guide investors toward the assets that align with their individual risk tolerance. Normally, a 35-year-old anticipating decades of potential earning power ahead might be willing to pay a higher risk premium than a 65-year-old who is ready to retire. Remember, a higher premium means greater risk and less certainty.

Your financial adviser can help you apply the equity risk premium when constructing your portfolio to reflect your personal level of risk tolerance.