The equity risk premium seems very high; but perhaps it has just been an unusually good century for equity investors.
It has been a good century for equity investors. Barclays Capital are proud keepers of records of returns on different asset classes since 1918. Over that period, equities have outperformed cash and bonds by around 6% per annum.
This finding is very robust. Over all but the shortest time periods this outperformance – the equity premium – has been consistently maintained. Research in the US suggests a similar figure has been true there.
The economic consequences have been profound. Institutional investment, once dominated by fixed interest holdings, is today is mainly in shares. Financial markets and corporate governance are organised around the central role of equity markets. Companies seek returns on investment that match equity investors expectations – 15% or more. So they look for deals, and narrow the range of their activities to focus on those that will assure these high returns. We invest relatively much less in infrastructure than our Victorian forebears.
There are good reasons why equities should yield more than safe assets. Risk is the essence of capitalism. The equity premium is what shareholders need to be paid for lying awake at night, tossing and turning, worrying about the fate of their investments. They could place their money on deposit, or in indexed bonds, and sleep more soundly. Bravely they have chosen not to. They need to be compensated for this disturbance to their tranquillity.
But at 6% per year? The UK stock market is capitalised at £1250 billion. That makes the annual compensation for loss of sleep £75 billion. About 10% of national income and £1300 per year for each man, woman and child in the country. And since most of these men women and children do not give a moment’s thought to the level of the stock market, the rest of us must be losing a lot of well-remunerated sleep.
Indeed, the rewards of risk-bearing are so high as almost to eliminate the risk itself. If equities outperform safe assets by 6% a year then the probability that you will do better in safe assets than in equities over a ten year period is negligible. This is the equity premium puzzle. The equity premium is the reward for risk, but the magnitude of the reward is wholly out of line with the magnitude of the risk
However you look at it, the equity premium is inexplicably high. What would happen if such returns persisted? The net yield on the All-Share index, which is what investors will receive next century, is today about 0.5% more than the secure return on indexed gilts. To provide a total return 6% higher than a safe investment in indexed stock, company earnings and dividends will have to grow at 5.5% per year – indefinitely. But the British economy does not grow at anything like this rate, and nor can profits and share prices. If they did, by the end of next century dividends would absorb more than half of national income and compensation for worrying about the level of share prices would be the main source of national income.
We can say, with certainty, that equity returns will not be as high in future as in the past and that people who look for 15% returns on assets are living a dream. That means that the last hundred years, in which the outperformance of equities has been a consistent theme, have been a fluke, an aberration. Hard to believe. Still, the improbable is more likely than the impossible.
But, on reflection, maybe it is true. There have been a whole series of special factors favouring equity investments. Some have been long term trends. Inflation has been faster than anticipated across most of the century. Quoted companies have become a far more important part of the economy. Short term influences have also boosted shares. The rerating of equities relative to other investments, rapid growth in productivity, a recognition of the importance of knowledge based assets.
Few of these factors favouring equities were fully apprehended before they happened. Imagine yourself seeking investment advice in 1900. Your uncle might have advised Buenos Aires tramways: Argentina was the coming place. Your grandfather might have recommended Russian bonds: however unattractive the Tsar’s regime, he offered a security unavailable in volatile democracies. Your cousin would have had confidence in farmland. And your father would have assured you of the stability of residential property. There would always be a need for central London mansions, and Shropshire estates. Perhaps a raffish great uncle might have recommended to you a small wager on the Atlanta pharmacist whose Coca-Cola beverage was catching on in the Southern states.
If you had taken him seriously, you would have more than compensated for the huge losses you would have incurred on the other, more prudent, suggestions. With the benefit of hindsight, we know that shares in British and American companies were the outstanding investments of the twentieth century. But that is with the benefit of hindsight: in 1900, other people were buying Argentinian tramways. And they might have been right in their investment decisions. If they had been, small investors would today be piling into tramway investments and we would be reading academic treatises on the tramway premium puzzle.
Past performance is not a guide to the future, as the advertisements say. We do not know what asset class will perform best over the next century because if we did that knowledge would already be reflected in the price. Your best strategy in 1900 was to take some, but not too much, of the advice of all your relatives and diversification remains the only key to security of investment performance.
Maybe this is the end of the century of equity outperformance. But do not rush to sell your holdings. It is almost fifteen years since two financial economists, Mehta and Prescott, first drew the attention of the academic world to the equity premium puzzle. They argued that it was much higher than rational economic theory could explain. The longest bull market in the history of investment followed.