This post on the equity risky premium is from former hedge fund manager turned author Lars Kroijer, an occasional contributor to Monevator. He also wrote Investing Demystified.

How much should we expect to make when we put our money into shares – preferably by investing globally with a world tracker fund?

In my opinion, our expectation should be driven by our view of the equity risk premium.

And what is the equity risk premium?

The equity risk premium is a measure of how much extra return investors in the stock market expect to be paid for taking on the additional risk of investing in shares, compared to if they’d invested instead in the minimal risk asset.

The minimal risk assets in the UK and US are those countries’ domestic government bonds.

Shares are much more risky than UK and US government bonds, but everything has a price.

That price is the equity risk premium.

What is the equity risk premium, in numbers?

When we look to the equity risk premium as passive investors – or as I like to say, as rational investors – we’re not trying to predict whether the prospects for the markets are particularly good or bad right now.

The equity risk premium simply acknowledges that historically, investors have demanded a premium for investing in risky equities, as opposed to instead investing in less risky assets.

By using the equity risk premium in our calculations, we’re saying we presume investors will expect to be paid a similar premium for investing in equities going forward to what they’ve demanded in the past (unless the risk of those markets has changed substantially compared to the past).

How much is that premium?

The size of the equity risk premium is subject to much debate, but something in the order of 4-5% is what you’ll typically see quoted.

If you study the performance of the global equity market over the past hundred years or so, the average annual compounding rate of return over that period is within this range.

Real returns 1900–2015

Source: Credit Suisse Yearbook 2015

Of course it’s impossible to know if the markets since 1900 were particularly attractive or poor for equity holders, compared to what the future has in store.

The equity risk premium is not a law of nature, and it will change over time as the data changes.

When I published my book, for instance, the same calculation we’ve just done produced a slightly higher equity risk premium of 4.5%, using returns over the period 1900 to 2011.

There is also some evidence that the risk premium changes with the level of risk (or volatility) in the markets – that is, that those brave enough to enter the markets at times of maximum turmoil and risk are rewarded with higher expected returns.

In general academics say there aren’t enough datapoints to make this argument convincingly, but the evidence does point in that direction.

Could the equity risk premium be different in the future?

The equity risk premium is simply an expectation of future returns.

There are various ways to calculate it, but here we’ve simply based it on what stock markets have achieved in the past – including all the booms and bear markets along the way.

To be sure, economists and finance experts disagree strongly on what we should expect going forward.

And some do consider this kind of projecting by looking in the rear-view mirror approach to be wrong.

But I disagree.

In my view the long and volatile history of equity market returns gives a good idea of the kind of returns we can expect going forward, provided we don’t try to be too precise.

Equity market investors have previously demanded a 4-5% return premium for taking on the kinds of risks equities entail, and assuming that those risks remain roughly similar to what they were in the past, it’s reasonable to assume a similar return expectation from here.

So I think there’s a good probability that going forward investors will demand a similar 4-5% return premium for a similar kind of risk.

Next week we’ll look at what the equity risk premium means for your portfolio. I’ve turned off reader comments for this first article, so we can have the discussion in one place then.

Lars Kroijer’s book is Investing Demystified. Lars is donating all his profits from his book to medical research. He also wrote Confessions of a Hedge Fund Manager.

Good reads from around the Web.

Anyone who knows they could save £300-a-year by switching their energy supplier but invariably finds a freshly painted wall that needs watching will agree that overwhelming choice is a curse.

I’m a bit nerdy about money and I know I should review all my standing orders and whatnot every 12 months or so, but to be honest I don’t.

Life feels too short to wade through all the alternatives – however much I tell myself the savings equate to a substantial hourly wage.

Happily I do manage it every 2-3 years. The worst kind of choice paralysis is when you never make the decision, with devastating long-term consequences.

It doesn’t really matter what brand of peanut butter you buy.

But it surely matters if you want a life partner yet keep dating until your life is half over because you just couldn’t make your mind up.

A plethora of potential portfolios

Closer to the soul of Monevator, it’s a bit tragic if you put off long-term investing not because you never took any interest, but because you did, only to find there were too many options to choose from.

A deep article on the paradox of choice in The Guardian has some insights on this:

Which of us, really, feels competent to choose between 156 varieties of pension plan?

Who wouldn’t rather choose to lie in a bath of biscuits playing Minecraft?

And yet, at the same time, we are certain that making a decision about our workplace pensions is an important one to get right.

But instead of making that choice, [the researcher says] many defer it endlessly.

One of his colleagues got access to the records of Vanguard, a gigantic mutual-fund company, and found that for every 10 mutual funds the employer offered, rate of participation went down 2% – even though by not participating, employees were passing up as much as $5,000 a year from the employer who would happily match their contribution.

We see something similar in comments on Monevator from people who’ve read all about the different portfolios in our passive investing guides but cannot decide where to get started – or when.

Some never do.

Similarly, while I doubt it’s useful to debate whether you should have 1.26% in frontier markets or just the 0.93%, I’m certain it’s better to think about it when the other 98% of your funds have been sensibly invested.

Choose life

This is why I often suggest to new investors that they just get started splitting their money 50/50 between cash and a UK tracker fund.

When I mention this, knowledgeable readers often protest, perhaps even with a strong dose of being aghast.

Haven’t we written reams about global markets, bonds, asset class diversification and so on? Surely I of all people should know that a 50/50 split between UK stocks and a bank account is not optimal?

Of course I do and no it’s not. But it’s inordinately better than not saving at all.

Like a lot of things – a good diet, jogging, going to nightclubs – investing gets more compelling the more you do it. Best just to get started, and to make refinements as you go.

[continue reading…]

A common reaction among my peers to the slow-motion car-crash that is the pensions crisis is: “We’re gonna have to work ’til we’re dead anyway.”

It’s a fatalistic, short-sighted, shoulder-shrugging attitude that translates as: “I’m not saving enough for my pension and I’m going to put off doing anything about it by pretending I can’t do anything about it.”

But of course there’s plenty we can do about it, and it only takes a quick play with a compound interest calculator to see that delay does nothing but make the problem worse.

Compound interest and time are the nitro and glycerin of personal finance. Except it’s a friendly explosion.

It’s well known that compound interest can turbo-boost your fortune. Initially the effect of earning interest on interest is small – almost invisible – but over time it accelerates dramatically.

Compound interest’s most spectacular effects occur in later years.

To maximize the miracle grow power of compound interest, it’s important to understand the major components that influence the effect:

• Time: The longer you can wait before you spend the money, the bigger the snowball effect of compounding.

• Interest rate: A small difference in the amount you earn makes a big difference over the long term.

• Tax and other costs: The less tax is clipped off your interest (or the longer you can defer the day of reckoning with the taxman) the more your returns will have had a chance to compound.

• Frequency of compounding: The more often interest is paid (such as quarterly or monthly), the quicker the compounding effect can get to work.

Time is the critical factor

Compound interest can do much of the heavy lifting towards your financial goals, if given enough time.

The Monevator millionaire calculator illustrates the point by showing how much you need to save every year to earn a million by age 65. ¹

• If you harness the power of compound interest from age 20 then you only need to save £2,581 per year to hit the target, assuming an annual average interest rate of 8%.

• A 30-year old who starts saving at the same rate ends up with less than half the amount by 65: £480,329.

• A 40-year old is left wondering where all the time went, getting only a fifth of the way to a million by 65: £203,781.

Here’s how much our 20-, 30- and 40-somethings would have to put away every year to earn a million at 65:

The differences are horrendous. Delay for 10 years and you must save at over twice the rate. Wait 20 years and you’re looking at saving more than five times the amount of a 20-year old.

Make your child a millionaire: If you’re expecting kids any time soon, you could make your child a millionaire by age 65 by unleashing the power of compound interest. Start investing for your kids from day one and if you earn an average annual interest rate of 8%, then tucking away just £1.48 a day will do the trick. Not a bad present in these days of pension insecurity. Just make sure they can’t get their mitts on the moolah a day earlier!

The interest rate matters

Seemingly small changes in the interest rate can have a profound impact on your final result. See how much less our protagonists need to save if we up the average annual interest rate to 10%.

Our 20-year old would-be-millionaire can save nearly 50% less per year by earning 2% more than in our previous example.

Stretching for yield works less well (and is considerably more dangerous) for the 40-year old, who can only reduce his annual saving amounts by around 25%, given the shorter time he has left.

Don’t sell yourself short

In contrast, things look considerably less sunny if we drop the average annual interest rate to 6%.

A 20-something investor earning 6% must save 81% more than a 20-something who earns 8%. With less interest to compound over the decades our young investor must increase their annual commitment, if they want to achieve the same financial goal in the same amount of time on the lower interest rate.

Meanwhile, our tardy 40-year old must find an extra 33% at 6%, in comparison to 8%.

The message is that it can pay to invest aggressively if you’re young and you can handle the risk. Sitting in low-yielding assets like cash or bonds is likely to cost you over the long run.

The historical return rate of the UK stock market is around 5% before inflation (add on about another 3% for that) while cash and gilts have brought in about 1%.

If you’re young then you have the time to hopefully take advantage of the peaks and ride out the troughs that come with an aggressive asset allocation tilted towards equities.

The table above also shows why you must guard against other assailants trying to mug your returns, such as the taxman and the expensive fund manager.

Make sure your money is tax-shielded in ISAs and pensions, and that you use low-cost index trackers so that the power of compounding has as much interest, dividends and capital gain to work with as possible.

The takeaways

• Don’t think that investing for the future can wait until later. The early years count. Start saving something now and do it regularly. The longer your investments have time to grow, the greater the power of compound interest to make you money.

• Be patient and think long term. Leave the money alone. Reinvest all your gains. The effect of compounding is miniscule at first and may seem agonisingly pointless. The most dramatic effects occur in the later years, but you’ll be grateful for them and will thank your younger self for your foresight.

• It’s never too late. You may have lost years to procrastination, financial naivety or whatever else – I know I did. But here’s a brilliant quote about letting go of the past:

The best time to plant a tree is 20 years ago. The second best time is now.

Forget about yesterday, and do something about tomorrow.

Take it steady,

The Accumulator

1. I’m not saying you need a pension of a million pounds. I’m simply using the figure to illustrate that compound interest can make the seemingly unachievable achievable.[↩]