The Equity Risk Premium

2002 was a tough year for the stock market. The S&P 500 fell 23.4%, while the Nasdaq dropped 31.5%. The overall market averages have now declined for three straight years, the first time this has happened since 1939-41. Many investors have given up on stocks. They're tired of throwing good money after bad and have decided to stick with money markets, bonds and real estate. But is this a good idea?

Here is some academic theory that might ease your anxiety about investing in stocks. A fundamental concept in financial economics is the risk-return tradeoff. An investor who is completely risk-averse will invest solely in Treasury securities. Treasuries are backed by the full faith and credit of the US government and are essentially risk-free. A rational investor will only accept investment risk if the expected return is higher than that of treasury bonds. Therefore, bonds issued by a company like General Motors have to pay a higher interest rate in order to attract investors. Companies with shaky credit ratings issue bonds that pay even higher rates of interest (junk bonds) to compensate investors for the risk of future bankruptcy.

The increase in expected return over the risk-free rate (i.e., the Treasury bond rate) is referred to as the risk premium. Stocks are much riskier than Treasury bonds and therefore should offer a substantial risk premium. Sure enough, if you look at historical returns, stocks have always outperformed Treasury bonds by a large margin over long periods of time (10-20 years).

During the latter 1990s, pundits theorized that the risk premium for stocks was getting smaller because there just wasn't that much risk anymore in the stock market. The market performance of the past three years should dispel that notion. In other words, there is still every reason to expect a substantial risk premium associated with investing in stocks.

Individual investors tend to be anything but rational. However, a funny thing happens when you look at the market as a whole. It actually behaves somewhat rationally. Stock prices continuously adjust to provide investors with an expected return well above that of Treasury bonds. If you are willing to assume the added risk of investing in stocks, you are entitled to a higher rate of return. Due to the greater volatility in stock market returns, you are likely to endure some rough stretches like the one we've just been through. Over the long run, however, a broadly diversified equity portfolio still offers higher expected returns than most other assets, such as bonds or real estate.

January 2003

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