GSB | Chicago: Nicholas Barberis on the puzzle of the equity premium

NICHOLAS BARBERIS SAYS LONG-TERM RETURNS FAVOR A BUY-AND-HOLD STRATEGY

It’s a well-known fact that the reward from holding stocks has historically been higher than that for bonds. The average annual real return on the U.S. stock market between 19261993 was 6.6 percent; long term government bonds earned 1.7 percent over these years.

The difference between the two, 4.9 percent, is called the equity premium. Is this equity premium, and the superior performance of stocks, simply compensation for their higher risk? A look at the data from a longer term perspective shows this is not the case.

The most direct measure of risk is standard deviation, which measures the dispersion in returns. Over the 18021992 period, the standard deviation of annual stock returns was 21 percent, as compared with 10 percent on bonds. For a long-term investor, though, a more useful statistic may be the standard deviation of average returns over 20-year periods. For stocks, this is 3 percent–less than the corresponding figure for bonds, 3.4 percent.

Why do stocks appear riskier than bonds at short horizons, but less risky at long horizons? Some economists believe this is caused by mean reversion. A bad year for the stock market is more likely to be followed by a good year rather than by another bad one. Bad years cancel out good years and vice-versa, so that over long periods of time, the risk of stocks is reduced. Taken at face value, the historical data seem to suggest that stocks are a superior investment.

Many investment analysts disagree. They claim that the 4.9 percent U.S. equity premium greatly exaggerates the future rewards from holding stocks over bonds. They blame a historical quirk, saying that government bonds suffered very low returns in the 1960’s and early 1970’s due to unexpectedly high inflation. Because we better understanding of the inflation process we should not expect future bond returns to be as low as they were in the past century.

Although there is undoubtedly some truth to this, it is not clear why bonds suffered. If it was inflation, why did short-term government bonds perform just as poorly as the longer maturity bonds? If we don’t fully understand the cause of the poor performance of bonds, it may be premature to argue that it is a thing of the past.

The question of the long-run risk of stocks is even more controversial. The 3 percent standard deviation of annual stock returns over 20-year periods suggests that mean reversion in stock returns makes the risk of stocks fall faster than that of bonds. Unfortunately, our data only goes back a few decades, so we do not have many independent 20-year periods to draw reliable inferences from. Formal statistical tests have been unable to establish convincingly that there is any mean reversion in stock returns, even if the raw numbers suggest it.

Mean reversion is often viewed with considerable skepticism because the predictability it implies appears to conflict with the idea that markets are “efficient” and that prices are “correct”. It is a common misconception that when prices reflect true fundamental value, they should move randomly.

In fact, mean reversion can be completely consistent with a world where prices are set rationally. All that is required is that the risk of stocks change over time. Suppose, that the market has plunged dramatically in the past few months. The drop may lead to a shift in risk perceptions: investors may decide that stocks have become riskier. Basic finance theory tells us that risk must be compensated by a higher expected return. Therefore, following the stock market plunge, we would subsequently see higher returns on average–a phenomenon that looks a lot like mean reversion.

Some analysts have claimed that standard deviation is an inadequate number to begin with because it misses a subtle but crucial form of risk: complete stock market collapse. Of the stock exchanges that existed at the turn of the century, as many as half experienced significant interruptions or were completely abolished. Looking only at the variability of U.S. stock returns misses this kind of risk because the U.S. market has never experienced such a collapse. This doesn’t mean that the risk of a future collapse is not present. However, if something occurs that is devastating enough to melt down the stock market, presumably it would also affect the bond markets.

These facts make the 4.9 percent equity premium all the more surprising. Why is the average return on stocks so much higher than on bonds when the risk of catastrophic collapse actually seems higher for bonds than for stocks? It seems that the simplest strategy–to buy and hold the market–may also be the best for most investors.

This article is adapted from one that first appeared in the Financial Times series “Mastering Finance,” number 8, May 1997.

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Nick Barberis

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					NICHOLAS BARBERIS SAYS LONG-TERM RETURNS FAVOR A BUY-AND-HOLD STRATEGY It’s a well-known fact that the reward from holding stocks has historically been higher than that for bonds. The average annual real return on the U.S. stock market between 19261993 was 6.6 percent; long term government bonds earned 1.7 percent over these years. The difference between the two, 4.9 percent, is called the equity premium. Is this equity premium, and the superior performance of stocks, simply compensation for their higher risk? A look at the data from a longer term perspective shows this is not the case. The most direct measure of risk is standard deviation, which measures the dispersion in returns. Over the 18021992 period, the standard deviation of annual stock returns was 21 percent, as compared with 10 percent on bonds. For a long-term investor, though, a more useful statistic may be the standard deviation of average returns over 20-year periods. For stocks, this is 3 percent–less than the corresponding figure for bonds, 3.4 percent. Why do stocks appear riskier than bonds at short horizons, but less risky at long horizons? Some economists believe this is caused by mean reversion. A bad year for the stock market is more likely to be followed by a good year rather than by another bad one. Bad years cancel out good years and vice-versa, so that over long periods of time, the risk of stocks is reduced. Taken at face value, the historical data seem to suggest that stocks are a superior investment. Many investment analysts disagree. They claim that the 4.9 percent U.S. equity premium greatly exaggerates the future rewards from holding stocks over bonds. They blame a historical quirk, saying that government bonds suffered very low returns in the 1960’s and early 1970’s due to unexpectedly high inflation. Because we better understanding of the inflation process we should not expect future bond returns to be as low as they were in the past century. Although there is undoubtedly some truth to this, it is not clear why bonds suffered. If it was inflation, why did short-term government bonds perform just as poorly as the longer maturity bonds? If we don’t fully understand the cause of the poor performance of bonds, it may be premature to argue that it is a thing of the past. The question of the long-run risk of stocks is even more controversial. The 3 percent standard deviation of annual stock returns over 20-year periods suggests that mean reversion in stock returns makes the risk of stocks fall faster than that of bonds. Unfortunately, our data only goes back a few decades, so we do not have many independent 20-year periods to draw reliable inferences from. Formal statistical tests have been unable to establish convincingly that there is any mean reversion in stock returns, even if the raw numbers suggest it. Mean reversion is often viewed with considerable skepticism because the predictability it implies appears to conflict with the idea that markets are “efficient” and that prices are “correct”. It is a common misconception that when prices reflect true fundamental value, they should move randomly. In fact, mean reversion can be completely consistent with a world where prices are set rationally. All that is required is that the risk of stocks change over time. Suppose, that the market has plunged dramatically in the past few months. The drop may lead to a shift in risk perceptions: investors may decide that stocks have become riskier. Basic finance theory tells us that risk must be compensated by a higher expected return. Therefore, following the stock market plunge, we would subsequently see higher returns on average–a phenomenon that looks a lot like mean reversion. Some analysts have claimed that standard deviation is an inadequate number to begin with because it misses a subtle but crucial form of risk: complete stock market collapse. Of the stock exchanges that existed at the turn of the century, as many as half experienced significant interruptions or were completely abolished. Looking only at the variability of U.S. stock returns misses this kind of risk because the U.S. market has never experienced such a collapse. This doesn’t mean that the risk of a future collapse is not present. However, if something occurs that is devastating enough to melt down the stock market, presumably it would also affect the bond markets. These facts make the 4.9 percent equity premium all the more surprising. Why is the average return on stocks so much higher than on bonds when the risk of catastrophic collapse actually seems higher for bonds than for stocks? It seems that the simplest strategy–to buy and hold the market–may also be the best for most investors.
			This article is adapted from one that first appeared in the Financial Times series “Mastering Finance,” number 8, May 1997.

			More about Nick Barberis

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