Larry Swedroe

It's Why They Call It The Equity "Risk" Premium

One of the most popular investment books of recent times was Dow 36,000: The New Strategy For Profiting From The Coming Rise In The Stock Market. The premise of the authors, James K. Glassman and Kevin A. Hassett, was that equity investing was not risky - as long as your investment was long enough, specifically twenty years. They presented evidence that the market had always outperformed fixed-income investments as long as the investment horizon was at least twenty years. The timing of the book's publication is particularly noteworthy, September 1999 - about six months before the collapse of the broad U.S. equity market indices.

The biggest problem with the book is the premise that stocks are not risky investments. After experiencing the bear market of 2000-2002, it's doubtful any investor today believes that stocks are riskless investments, regardless of the investment horizon.

Equities have provided higher returns than fixed-income investments over the long term simply because investors know that they are riskier, and thus demand an equity risk premium as compensation for accepting that risk. There are, however, other problems with the book. The first is that the authors based their conclusions on the historical returns of only the U.S. equity market. We know today that U.S. equity investors have been rewarded for taking equity risk over the long term. However, there are many examples of investors in other countries that did not fare as well, and the risks of equity investing showed up. A very recent example is the Japanese Nikkei index hitting a twenty-year low in 2002, while bond prices were rising as interest rates fell dramatically. There is no guarantee that U.S. investors will fare as well in the future as they did in the past (remember the Japanese economy, as recently as 1990, was the envy of the world). If a theory is correct, in this case that equities are less risky than fixed-income investments if the horizon is long enough, then it should apply no matter which country an investor calls home.

Another problem is the authors got their facts wrong. In fact, not only had stocks not always outperformed fixed-income investments if your investment horizon was at least twenty years, they had not done so even if your horizon was at least twenty-five years. Let's roll the videotape. For the twenty-five year period 1966-1990, U.S. large-cap growth stocks returned 8.2 percent. Over the same period, riskless one-month certificates of deposits outperformed those glamour growth stocks (the stocks of the great companies that dominate the broad market indices, and the stocks that most investors believe are not only the safest investments, but the highest returning ones as well), returning 8.3 percent. That is not the only example that the authors somehow overlooked. For the twenty-one year period, 1929-1949, while the S&P 500 index was rising just 3.8 percent, long-term government bonds (average maturity twenty years) returned 4.0 percent.

The bear market that began shortly after the authors predicted a dramatic rise in the market provided another example of the faulty premise that is the basis of the book. For the twenty-two year period January 1981-December 2002, the annualized return of long-term U.S. Government bonds was 11.92 percent. They outperformed both the Russell 3000 index (11.70%) and the Wilshire 5000 index (11.63%). Equities are risky regardless even with long investment horizons. And we never know when the risk will show up. It is why investors price equities in a manner that is expected to compensate them for taking that risk. And it is why the long-term outperformance of stocks over fixed-income investments is called the equity risk premium, and not simply the equity premium. The word "risk" is there for a very good reason.

Professor Jeremy Siegel also wrote a very popular book, Stocks For The Long Run, with a similar premise to that of the Dow 36,000 book. The premise of Siegel's book is that if your investment horizon is long enough, fixed-income securities, not equities, become the riskier investment because of inflation risk. One problem is that this considers the risk of inflation, but not deflation - in which case, and Japanese investors will attest to this, stocks become the far more risky investment.

Equity investing entails more risk than fixed-income investing, regardless of the investment horizon. Thus equities do have higher expected returns. It is also true that the longer the investment horizon, the more likely it is that stocks, because they have been priced for the greater risk, will provide higher returns than fixed-income investments. However it is never certain that they will do so, no matter how long the investment horizon.

Recognizing that equities are risky investments, prudent investors plan for that risk. Prudent investors also know that history teaches us that just because something has not yet occurred, does not mean that it cannot, or will not, occur in the future. Therefore, prudent investors build an investment plan that allocates assets to equities and fixed-income investments in a manner that takes into account not only their investment horizon, but also the stability of their earned and unearned income, their willingness to take risk, and perhaps most importantly, their need to take risk. In summary, a well-thought-out investment plan takes into consideration the possibility of events that are even highly unlikely to occur (e.g. stocks underperforming fixed-income investments in the long term). It also avoids the mistake of focusing solely on the length of the investment horizon as the determinant of the equity to fixed-income allocation.