Why You Should Stop Worrying and Learn to Love the Market
Is it possible that the
skyrocketing stock market is in fact underpriced? Is the recent market
turbulence just a tiny price that long-term stock-market investors pay to enjoy
very large excess returns over bonds? Or, to put it another way, were investors
whining during the recent downswing about the exact reason they get such
spectacular long-term returns?
These
possibilities are raised by an article in the latest Journal of Economic
Perspectives , and by a gloss that contemporary history suggests be put upon
it.
The article, titled "The Equity Premium Puzzle," asks a
question that should strike joy in the hearts of stock-market investors. Why,
ask noted finance experts Jeremy Siegel of Wharton and Richard Thaler of the
University of Chicago, has the long-term rate of return for stocks consistently
been so much higher than for fixed-yield assets? Over very long periods of
time, the excess return of stocks over bonds yields staggering differences in
profit.
For
example: Ibbotson Associates, the finance-statistics firm, has found only one
20-year period, from late 1928 to late 1948, when the rate of return on
Treasury bonds exceeded the return on the S&P 500, and that was by a small
fraction of one percentage point. This period included many start points when
pundits opined about the excessively high price of stocks. Another example that
Thaler and Siegel use is particularly attention-getting: If you had bought
$1,000 worth of Treasury bills in 1925 (because you were worried that the stock
market was considered too high and too speculative), and held them until the
end of 1995, you would have $12,720. But if you had put the thou into a broad
portfolio of stocks, you would have $842,000. The difference comes from an
average rate of return for the bills of 3.7 percent and for the stocks of 10.1
percent.
Finance experts call this difference in yields
between stocks and bonds the "equity premium" or the "equity-risk premium." It
is the premium in the form of a lower rate of return that investors are willing
to pay to own bonds or notes rather than stocks, supposedly because stocks are
a great deal more dangerous. But what Siegel and Thaler ask--and what many of
us investors have long asked--are two key questions: 1) Why is the risk premium
as high as it is? 2) Why, for some investors, especially long-term holders,
should there be any risk premium at all?
As to the
first, Siegel and Thaler use a series of complex equations and models to find
(as have other academics whom they cite) that the risk premium over the past
two centuries has been almost insanely high. In fact, even for any 20-year
period, the standard deviation of stock returns from the average return--i.e.,
the range within which two-thirds of all returns fall, used as a rough measure
of volatility--is far smaller than would justify the immense premium investors
give up to own bonds or bills with definite coupons and payment on maturity.
Or, to put it another way, looked at from the perspective of time, stocks are
simply nowhere near as risky as their rate of return compared with bonds would
seem to indicate, at least so far in finance history.
The authors find, moreover, that this is a worldwide
phenomenon. Even in nations where stock exchanges disappeared or were curtailed
due to war or political catastrophe--such as Japan or Germany--returns to
stocks exceeded returns to bonds over long periods.
Only when stock returns are
considered on a year-to-year basis is there even a hint of enough risk in
stocks to generate a risk-aversion premium such as exists. And even there, the
fluctuations do not appear to compel as large a risk premium as exists, unless
the aversion to risk is irrational.
But the
second question is even more beguiling. Why should there be any risk premium at
all for long-term investors if, on a consistent basis since the beginning of
the 19 th century, the returns to long-term stock-holding have been
and are dramatically greater than to debt-holding? Why shouldn't investors sell
bonds and buy stocks to the point that bond prices are so low and stock prices
so high that the returns on bonds over time approximate the return on
stocks?
How long, Thaler and Siegel ask, will it take
most investors to get wise to the fact that the equity premium is just too
damned high? They assure the readers that they, like most economists and
finance people, have their retirement savings in stocks. They say they know
that over the next 20 years, if not for the next few years, they will be safe
in predicting that stocks will outperform bonds no matter what the short-term
turbulence. (Indeed, they point out, over 20-year periods, bond returns
actually vary more widely than stock returns.)
And here, current history
adds a major point. If all (or most) holdings were for only a year, one could
see why stocks--which can fluctuate scarily in a year--might command a large
risk premium. But if the composition of the market has changed considerably, so
that it is now composed largely of baby boomers investing with a 20-year--or
greater--horizon, might this not change the valuation of stocks, bid up their
prices, and lower the equity premium? Especially now, when any investor can
obtain almost perfect diversification with index funds and index options--and
thus get the exact return of the market as a whole.
More immediately important,
it puts the market's recent, quickly overturned correction in quite a different
light. All that volatility, upsetting as it may be for the short-term trader,
is simply the small price stock investors pay for vastly superior long-term
returns. If we didn't have this kind of upsetting move occasionally, we would
not get the risk premium at all, because then everyone would only want to hold
stocks. Maybe we should stop worrying and learn to love this roller coaster,
which has its dips but really does eventually climb to the sky--or at least has
done so thus far.
