The equity risk premium and YOU

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

We’ve previously seen how the equity risk premium was 4.3% during the period 1900-2014.

All very interesting – but what’s it got to do with you?

Well, I’d argue we have good reason to expect global equities to outperform UK and US government bonds by a similar magnitude of 4-5% in the future, too.

This means you can plug this sort of real return figure – say 4% – into your compound interest calculators and other such tools when working out how equities fit into your investment strategy.

It’s a practical way of dealing with the uncertainty of shares.

A real return, but not a certain one

Now, some people do criticise this approach.

They argue that using historical returns to predict future returns will lead you to expect higher returns at peak markets, and lower returns at market lows.

And to be sure, historical returns from UK equities looked a lot better on 1 June 2007 – before shares crashed in the financial crisis – than on 1 March 2009, in the depths of the aftermath.

Even worse, perhaps it was because you were attracted by the high historical returns you saw in the data in mid-2007 that you decided to invest in equities – retrospectively right at a market peak.

Combining high historical returns with low expected risk made equity markets look most attractive, just when in hindsight they weren’t.

I understand this criticism but – aside from the general unavailability of crystal balls to predict short-term stock market crashes – I think the length of data mitigates it, at least when we’re involved in long-term planning, not market timing.

With hundreds of years of data across many geographies – incorporating spectacular rises, huge falls, and everything in between – I think historical data is the best guide to the kind of risk and return we can expect from the equity markets going forward.

A more practical complaint is that in the past investors couldn’t actually buy the whole world of equities.

One of the leading index providers, MSCI, only started tracking a ‘world index’ in the late 1960s.

Easily investable products that followed this or similar indices did not arrive for decades after.

So perhaps investor expectations have changed – and the equity risk premium shifted – due it being easier and cheaper to invest in globally diversified equities now than was previously the case?

Time will tell.

Alternative approaches

It’s worth noting there are other ways to derive a figure for your expected returns from equities.

For example, you might look at the dividend yield of the stock markets, or the average P/E ratio.

Combining either of these measures with longer-term earnings growth estimates can yield you an estimate of projected stock market returns.

The problem with these measures is they use quite short-term financial data, and combine it with a highly unpredictable long-term growth rate in order to extrapolate something as uncertain as future stock market returns.

To be honest, I don’t see that as an improvement on looking at historical data.

Other people suggest conducting surveys asking investors what their projections are for the markets, to try to gauge what returns they’re demanding.

While an interesting idea, these surveys are criticized for being heavily sentiment-driven.

They might also tell you more about investors’ desired returns than what they actually expect to earn.

Lars’ predictions

On average I expect to make a 4-5% real return per year above the minimal risk rate (that is, the return I can get from short-term US government bonds) from a broad based world equity portfolio.

This is the figure I’d use in my financial planning when figuring out what I hope to achieve over the long-term.

Of course I do not expect this return to materialize every year.

However if I had to make a guess on the compounding annual rate from global equities going forward, I would plump for this sort of range.

Expected future real returns

World equities	4.5-5.5%
Minimal risk asset	0.5%
	—-
Equity risk premium	4-5%

 

Note that while the equity premium here is compared to short-term US bonds, I would expect the same premium to other minimal risk currency government bonds.

This is because the real return expectation of short-term US government bonds is roughly similar to that of other highly rated countries such as the UK, Germany, and Japan.

Apologies in advance

By the way, if you consider these expected returns to be disappointing, I’m sorry.

Writing higher numbers in this article or putting them into a spreadsheet won’t make them true.

Anyway a 4-5% annual return premium to the minimal risk asset if achieved will quickly add up to a lot. You could expect to double your money in real terms roughly every 15 years.

Indeed, some people would suggest that by expecting equity markets to be as favourable in the future as in the past, I’m indulging in wishful thinking!

Why the risk premium exists

It may sit wrong withyou to have something as important as what you can expect to make in the stock market be based on something as unscientific as historical returns – or for that matter my ‘guesstimate’.

Perhaps so, but until someone comes up with a reliably better method of predicting stock market returns it’s the best we have, and in my view a very decent guide.

Also, it’s not superstition we’re dealing with here.

We know that the equity premium should be something – because if there were no expected higher rewards from investing in riskier equities, then we would all simply keep our money in low risk bonds.

Another argument with simplistically predicting a stable risk premium is that we don’t change it much with the world around us.

It doesn’t seem right that the expected returns going forward should be the same in the relatively stable period preceding the deep stock market crash of 2008, say, as during the height of panic in October of that year.

Did someone who contemplated investing in the market in the calm of 2006 really expect to be rewarded with the same return as someone who stepped in during the despair and frenzy of October 2008?

Very probably not; someone willing to invest at a moment of high panic would likely expect to be compensated for taking on that extra risk.

This suggests the equity risk premium is not a constant number, but is somehow dependent on the risk of the market.

At a time of higher expected long-term risk, equity investors will likely be expecting higher long-term returns.

We might therefore think of the 4-5% equity premium I’ve outlined as an expected average based on an average level of risk.

Putting the risk premium into practice

In the interest of trying to make something as complicated as the global financial markets into something almost provocatively simple, here is a chart showing what we can expect in terms of returns after inflation.

The graph shows how as risk increases, so does our expected return.

So if you’re an investor who wants to achieve returns in excess of the minimal risk return, you can invest in a broad portfolio of world equities.

In my opinion you can reasonably expect over the long-term to make a real return of 4-5% per year above the rate of minimal risk government bonds, which I expect to be about 0.5% per year.

However you can also expect your annual return to vary significantly, with a standard deviation of about 20% per year.

If that sounds too risky to you, you can combine an investment in shares with an investment in minimal risk government bonds to find your preferred level of risk (that is, volatility).

Minimal risk	Low risk	Medium risk	High risk
100% Bonds	75% Bonds	50% Bonds	0% Bonds
0% Equities	25% Equities	50% Equities	100% Equities

By varying the ratio of equities to bonds, you can blend your portfolio to suit your best guess of your individual risk tolerance.

Adding a greater percentage of bonds reduces the volatility in your portfolio, at the expense of reducing your returns.

Simple is best

I believe by following such a strategy you will do better over the long term than the vast majority of investors who pay large fees needlessly to earn consequently poorer investment returns.

Such a strategy can be enabled by combining just two index tracking securities – one tracking your minimal risk asset, and one tracking the world equity markets.

If this seems just too simple then remember your simple portfolio hides a lot of complexity below the surface.

Your world equity tracker is giving you exposure to a large number of often well-known companies, operating in many currencies all over the world. From just your two securities you are therefore getting amazing diversification, along with a minimal risk security in the shape of government bonds that give you the greatest amount of security possible.

An excellent portfolio made up of just two securities… Who said investing had to be complicated?

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