Equity Risk Premium: Do Stocks Always Beat Bonds?

In the 19th century U.S. stocks didn’t provide an excess return over bonds from 1803 to 1871. Then in 1871 equities beat stocks for the next 58 years until the great crash of 1929. A popular myth is that if you buy equities they will provide an equity risk premium of 4% higher than bonds. However this may only be true over a period longer than one’s lifespan. Often an investor accumulates wealth from age 45 to 65 and then retires and experiences a 20 year retirement. Thus his total investment time frame is 40 years, which may not be long enough enjoy an era when the equity risk premium is “normal” and is providing a higher return than bonds. For much of the past 30 years from 1982 to 2012 bonds beat stocks. It was only in the past 1.5 years that equities reversed and began to beat stocks. See the article by Rob Arnott in March, 2011.

What this means for investors is that one can’t rely on simplistic heuristic shortcuts like “equities beat bonds because they have more risk”. That may be true if you are managing a pension fund with century long horizon, but if you are 55 years old and will retire in ten years it is possible the next 30 years, assuming it is 1982, there would be no equity risk premium. Today it looks like stocks are overpriced by 63% and long term bonds could be overpriced by 12%. It is entirely possible that a stock index fund starting today will have a lower return than bonds until stocks fall down to a bottom at a fair value. The implication, based on PE10 theory and Tobin’s Q is that stocks need to go down to 1100 for the SP500 to reach fair value.

The investor’s best defense is to:
1. Don’t assume a simplistic benchmark is always relevant and applicable. You may not be able to outlive the dramatic changes in the equity risk premium.
2. Avoid overpaying for any investment whether it is stocks, TIPs, “A” paper bonds or “B” paper bonds or real estate or commodities.
3. Learn as much as possible about subtle investment concepts and develop an independent viewpoint – avoid being brainwashed by the masses, especially during bubbles.

Today the typical stock market bullish advisor tries to build a case that there is no bubble because the PE ratio is not as high as in 2000. But year 2000 was truly one of the world’s greatest bubbles. Two wrongs don’t make a right and certainly are a poor benchmark. If the 1998-2000 tech bubble had not occurred then ironically the current bubble would look much scarier and would be seen as matching other previous bubbles. Just because the Federal Reserve was able to bailout the economy is no guarantee that they will be able to repeat that during the next crash, especially since rates are very low and there are similar debt bubbles in Japan, China, southern Europe.

The typical investor who may have only a decade to save before retirement can’t afford to lose money, so he must heed the risk that the equity risk premium can misbehave for 68 years! If you are 45 to 55 years old today and the equity risk premium creates a 68 year bear market then you would need to wait until you are about 120 years old for things to work favorably, unless you adroitly avoided the problem with counter-intuitive contrarian investments.

Investors should seek independent financial advice about how to understand the hidden subtleties of the equity risk premium.

Investors should seek independent financial advice about how to protect their investments from the risk of misbehavior by the equity risk premium. I wrote an article about “Which are riskier – bonds or stocks?”

About the author

Don Martin, CFP®

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