Why do stocks pay more than bonds? That’s the question a NYT column looks at this Sunday. Interestingly, why the risk premium is so high can have implications for the economy:
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Nyt_viewinline"You might think that the nation’s high priests of finance would have agreed by now on why stocks have paid much higher returns than bonds over the years.

You’d be wrong. But depending on whose explanation you believe, there are some important implications for the economy’s future. The outlook may not be so good, at least not for everyone.

As every first-year finance student knows, there is a not-easily-measurable number called the equity risk premium. Simply put, this premium is the extra return that stocks have to pay, because they’re riskier than safe government bonds, in order to attract investors. It’s the same reason that individual numbers on a roulette wheel pay more than odds or evens: higher risk, higher return.

For decades, the returns on stocks have usually been much higher, relative to bonds, than risk alone would seem to justify — perhaps as much as six or seven percentage points higher. If risk were the only explanation, the difference would suggest that investors were extremely risk-averse, to the point that they would never leave the house for fear of having to cross the street.

Some economists have suggested that the equity risk premium is reasonable, if you account for very rare but very costly events, like depressions and wars. But there is still much debate, and there are other explanations for the gap in returns."

I suspect its more than just "Risk" that accounts for the premium: Its complexity, its an individual’s lack of managerial competance vis a vis their investments. For most investors, Bonds are simply bought and held to maturity. Stocks, on the other hand, require far more oversight.

It is that ease of ownership that leads to increased demand forBonds –  and their relatively lower returns:

"Think about the two types of securities in terms of supply and demand. The market for safe government bonds includes investors who can’t buy stocks at all: foreign central banks, other government agencies, some institutional money managers and certain kinds of trusts. Moreover, financial planners may be too eager for their clients to buy safe government bonds. If their paychecks depended solely on whether their clients made or lost money, they might try to avoid losses at all costs.

In other words, it may just be ridiculously easy to raise money for bonds. Or investors’ expectations of stock returns may be irrationally low, focused more on crashes than booms. Either way, the equity risk premium wouldn’t explain the entire gap in returns. .

We do know, though, that the risk premium must be some part of that gap. According to research by William N. Goetzmann and Robert G. Ibbotson, two finance professors at Yale, that premium has stayed fairly constant over long periods through virtually all of American history. For lack of a better reason, there may just be something special about American capital markets, so that a high equity premium would tend to revert to some sort of long-run average. In other words, the equity premium may be a partial predictor of future stock returns and even the future growth of the economy."

We’ll see if that turns out to be true soon enough . . .

Source:
Why Do Stocks Pay So Much More Than Bonds?
Economic View
DANIEL ALTMAN
NYT, February 26, 2006
http://www.nytimes.com/2006/02/26/business/yourmoney/26view.html

Category: Investing

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12 Responses to “Equity Risk Premium”

  1. vak says:

    i don’t buy it.

    i mean arbitrage need not be a sole supply side issue, that is, if bond financing was so cheap why do corporations still bother to issue shares altogheter ? sure all small caps cannot easely tap the bond market, but what about cisco and msft ? surely enought more ndx100 corporations could sell bonds (either strait or CDS).

    equity premium exists because equity financed institutions are more profitable than bond financed corporations.
    it’s a corporate governance issue if u will : somehow corporations seem to be better managed when pressured by WS analysts than when left private.

    that one thing, namely the positive effect of public/democratic oversight over private corporrations was accidently discorered here {where i’m tipping these lines} , in western UE in the 16th century,
    and has fueled our eco growth since.

  2. spencer says:

    I often wonder if the entire concept of a risk premium is useless.

    Why should anyone be surpised that the returns to ownership of productive assets are much higher then ownership of debt.

    Wouldn’t it be completely illogical if it were the other way? That would imply that it would be illogical to use debt financing for capital spending.

  3. No, the equity risk premium is not like routelette (link is to my blog entry responding to the NYT author).

  4. Uh, that would be roulette.

  5. Estragon says:

    Strikes me as apples and oranges. For starters, why would you compare “expected annual return of the S&P500 over the next 10 years” to a 10yr treasury in the first place? Surely, you’d want to compare equity returns to corporates, which trade at variably higher rates. Then you’d want to allow for survivorship bias in the S&P, since bondholders fare better with the duds. Then there’s tax efficiency, which will vary with the circumstances of the issuer and the investor. Etc. Etc.

    At the end of the day, I expect a complete analysis to suggest that the risk-adjusted returns for equity and debt converge overall. If there really was a free lunch to be had, the world be awash in hedge funds short bonds and long equities.

  6. areyburn says:

    According to Sir John Templeton, democracies always tend toward inflation (as an escape.) It could be that bond owners are really the short term money — reliability. Over shorter periods, inflation, or maybe even un-dis-inflation is more damaging to stocks than it is to bonds (what’s the return on the stock market over the past six years?) I remember reading a Barron’s interview many years ago that was bullish on stocks because (basically), we were still unwinding from the severe inflation of the ’70s.

    Another thought: The one major “natural” bond buyer is life insurance companies. They arbitrage bonds to average life expectancies. Not sure how much difference that makes, but maybe life insurance disintermediates the stock market???

  7. mozart325 says:

    The roulette analogy-

    “It’s the same reason that individual numbers on a roulette wheel pay more than odds or evens: higher risk, higher return.”

    is incorrect. I lost respect for the author after that. Both roulette bets would yield negative returns in the long term, but at most casinos the lower volatility odds/even bet will lose less in the long term than the individual number bet.

    The equity risk premium is something for economists to talk about, but is pretty much ignored by practitioners. The highest investment returns have been generated using very low risk strategies such as market making or arbitrage.

  8. Intriguing. I just wonder whether perhaps the return on Treasury bonds – the other part of the equity risk premium equation – has risen? After all, until recently, 30 Treasury Bonds were not being issued, so down went the supply of paper. Meanwhile, on the demand side, with huge monetary displacement effects (Kindleberger) like 9/11, the global supply of money has rocketed – so everyone has had to chase more returns. Even on those “safe” US government bonds…

  9. STS says:

    Barry,

    You might enjoy DeLong’s take on Weitzman at:
    http://delong.typepad.com/sdj/2005/06/notes_urap_proj_1.html

    This has more to do with the risk aversion inferred from the observed equity premium, but the whole subject of “equity puzzles” is shot through with confusion which probably stems at root from bad statistical technique on the part of (a generation or two of) economists.

    The treatment of equity puzzles by Jobert, Planaria and Rogers at:

    http://www.finance.group.cam.ac.uk/PREPRINTS/EPP.pdf

    is almost the same as Weitzman’s, but does the statistics in a more consistently Bayesian manner where Weitzman equivocates between Bayesian and frequentist methods (presumably from lesser technical familiarity).

  10. c.w. says:

    what’s your opinion of people like phil town (www.philtown.typepad.com) who suggest that owning & managing stocks can be done in a minimum of time?

  11. Jim Caserta says:

    In a simple sense, I think the difference in returns is due to access to profits. If you buy bonds, you only have access to the pre-arranged level of a company’s profits. If you buy stock, you get access to all the future profits of a company. I disagree with the analogy to roulette, from the point of view that stocks can generate near infinite returns, while even the longest odds in the roulette wheel will generate a fixed return.

    From the other point of view, if you KNEW (or were very confident) your company was going to generate > 10% returns, why would you ever sell stock when you could borrow for < 10%?

    My idea is limited to new issue of stock vs. existing equities. Any theory is also limited by observation window. How did someone who was 80 years old in 1980 view stocks? He had seen his retirement savings, assuming they were in stocks, stay the same for the 15 years he had been in retirement. Much different than the hypothetical 80 year old would view stocks in 1995. In the “short” term, stocks always have the potential to become over/under valued which will affect their returns from a given point in time.

    There has to be a mathematical model you could plug something like the Russell 2000 or 5000, or any large sampling of equities and use some probability to generate possible return scenarios.

  12. Erwan says:

    Nice… Lots of funny pictures !!!
    Just go on !