Monday, July 13, 2009

Is the Equity Risk Premium Actually Zero?

One of the most important constants in finance is the Equity Risk premium, that expected return on the signature risk asset, equities, over the risk free alternative (usually, long-term Treasuries). It's the one risk premium that is generally considered positive, too large even, which is a relief because in most areas the returns are decidedly negative for taking more risk. Estimates in the early 1990s were about 8%, now, around 3% annually.

In today's WSJ Jason Zwieg goes over a flaw in Jeremey Siegel's famous stock return estimate going back to 1802. As one would expect, stock indices prior to 1871 have a lot of survivorship bias issues. He suspects Siegel's index accounts for only 5% of equity investments actually available, and so could be severely biased, because the difference between the winners, and the average, is usually quite large. This highlights the many subtle biases in historical asset returns.

I have found that on average industry stratistics are maintained by biased parties, because those who do the work collecting such data invariably have a vested interest in the asset class, and incentives matter. Little things like selection biases in historical reconstructions, corporate actions, can get very detailed and matter a great deal. I have seen performance records where I had inside knowledge of the guy's strategy, and every time their performance was exaggerated. People exaggerate with a rather straightforward, self-interested bias on things that can help them, and index creators invariably have a rooting interest in the asset class they are 'merely monitoring'.

Is the equity premium really zero? I think for the average investor, yes it is, and it's a central issue in my book, Finding Alpha. As that old classic noted, the question 'where are all the customer's yachts?' answers itself.

Consider the following annualized adjustments that mainstream economists apply piecemeal, though when considered in total take the current estimate of 3% well below zero:
  • Geometric vs. Arithmetic averaging: 2% (See Dimson, Marsh, and Staunton). This is where a stock going from 100, to 200, back to 100 has an arithmetic return of +25%, the geometric lower, at zero. Geometric is relevant to the long-term investor, and most investors have a much greater volatility than the indices, making this estimate conservative.
  • Survivorship Bias/Peso Problems: 3% (see Rietz, Jorion and Goetzmann, Barro) The US is the best market in the 20th century, so not a good datapoint for an 'average' going forward.
  • Taxes: 3% (see Gannon and Blum, 2006). Since 1960, the after-tax equity premium is reduced to about 60 basis points is you assume 20% turnover and a top tax rate.
  • Adverse market Timing: 3% (See Dichev, 2005). Alas, most inflows are at peaks, outflows in troughs. The average dollar invested has experienced a much lower return than the annual averages.
  • Transaction Costs: 2%. historically, commissions were about 60 cent/share until the 1975 deregulation, and are currently w about 2 cents a share (about 0.1%) on average. Plus, mutual funds often had 8.5% fees. Trade impact is rarely mentioned, but for an institution it is unavoidable, at least 0.2% one-way. Lastly, the bid-ask spread will cost you about 0.25% on average if you cross it, much more historically. It doesn't matter than some passive funds have negative expenses, because we are talking about a hundred year average for your average or marginal investor.

The bottom line is these are all individually very modest adjustments, and so the current 3% equity risk premium is well below the total 13% adjustment. Like the OJ evidence, you can throw out ANY ¾ of the evidence and the equity premium is zero! Caveat Emptor.

(double click to go to YouTube, where you can see the second part of this video thread)

Part 2:


Anonymous said...

Good points

I think Zweig is right to at least ask questions about Siegel's data gathering process. I think Zweig really misses the forest for the trees, though. It’s not just that Siegel’s data is suspect, it’s that most historical data is irrelevant for the purpose of estimating long-term forward looking investment prospects.

Arnott and Bernstein made an interesting point in an FAJ article a few years ago. Say that world equity and bond markets today have a market cap of about $60 trillion (say the MSCI ACWI and the Barcap Global Agg). Go back to the year 1 AD and invest $1in "the market". What rate of return would you need for the $1 to grow to $60 trillion 2,008 years later? About 1.59% per annum...nominal.....That's for $1 of capital. If you tried investing $1000 in 1 AD then the rate of return necessary to own everything today would decline to about 1.24% per annum...Obviously these low returns do not conform with our personal aspirations. These low returns suggest that expropriation risk/revolution risk is significant. Basically just another version of the survivor bias you referred to…non-survivor bias…The Arnott and Bernstein observation(mentioned also by Marty Leibowitz)has been ignored and will probably continue to be ignored. Why?

In the Gallic Wars Caesar wrote that people willingly believe what they want to believe. Zweig and most of us want to believe that as investors we are peddling substance and not just entertainment value, that we are producing value for society and not just seeing how much the gullible and uninformed will pay for our sales pitches. As a result we find data to puff up the importance of our efforts. It's possible (who knows how probable)to think that, commercial motivations aside, Siegel was just a good scholastic trying to figure out how many angels can stand on the head of a pin/estimate the size of the equity risk premium. Siegel clearly was trying to measure historical rates of return. What we want as investors is to know what the future will look like. Siegel, Ibbotson and the crews at Chicago, Yale, UCLA and Harvard may believe that the past is prologue, that returns come from a stationary return distribution. It’s a commercially convenient belief. Zweig, though, acts as if the data from 1871 to the present or 1925 to the present is of some use. Historical data is really only useful if returns are stationary. Otherwise, who cares? One cares when trying to shape the expectations of fee paying clients.

Fischer Black loved introspection because he thought that sifting through data was a mugs game and that all one can do with one's life is follow one's beliefs. Zweig perhaps acts as if there is real Glengarry data just waiting to be found. Maybe it exists, or maybe it doesn't....Zweig may be well intentioned but misguided. Arnott and Bernstein/Leibowitz might have dreamt up an interesting though experiment, but the message has little appeal to the “representative” investor because it is so depressingly unappealing.

We as investors can think rationally, but the desire to make money usually sucks us back into the fold of spinning stories and torturing data.

bjk said...

Thanks for that video. I've seen them all and they're very helpful.

Anonymous said...

Taxes, Market Timing, and Transaction costs all affect any type of investing, not just equities. Furthermore, because capital gains often have less tax drag than interest coupons, taxes affect the equity premium far less.

Anonymous said...

Probably not the right spot for this.

But any comments on this article?

RB said...

Abnormal Returns linked to this article earlier this year which adds to the survivorship bias point that you make.

dave.d said...

The majority of the various "adjustments" suggested as reducing the equity risk premium to zero are largely avoided by a buy-and-hold investor in an index fund.

Walt French said...

Nice vid.

I think it could be even MORE interesting if you did the math & see who's benefitting from these costs.

The tax goes to Uncle Sam; relatively straightforward. At least we get highways, wars and border security.

The tendency to buy high and sell low? For the system, that has to be a zero sum game... how would it be possible for EVERYBODY to do it? There are several very nice studies that show how individual investors enrich other, perhaps more disciplined investors who are happy to take chances after a big drop, and individuals are selling. You might want to take a long hard look at your discipline.

Ahh, but those those market impact costs... one-fifth of a percent in a typical trade.The research I see -- my own proprietary data and studies I trust -- suggest that they're in the ballpark, maybe low by half. If every trader is paying those, as it seems, then the middleman is collecting. A couple billion shares a day isn't unusual these days, time 0.2% times a $10 stock, comes to roughly $40 million a day, $10 billion a year of revenues for the brokers. Hidden cost to you, but not to our friends on Wall Street.

Didja look at the latest quarterly earnings of those shops? ... when there is ZERO IPO activity, they still crank out massive numbers from... those of us watching videos on the internet.

Goldman Sachs -- and its mavens who often take a few days off work to do pro bono work as Treasury Secretary, etc. -- thank you.

Andre Veloso said...

Eric, you may be right and I agree that equity risk premium may be lower than the 8% or 3% you state, but a very important consideration must be made:
- When you say about studies that calculate the effects on taxes, transaction costs, etc. you just can't subtract all these costs from the 3%. You have to make a new estimate multiplying ALL the costs, taking into account a new 3% risk premium. All these costs reduces a proportion (say 50% of the 3%), and not an absolute number.