After investing for ten long years and ending up with less capital than they invested, many are questioning the wisdom of long-term ownership of stocks. While I think bonds have a place in even the most aggressive portfolio, it would be a mistake to extrapolate the recent poor run in stocks far into the future and give up on stocks altogether. This post on Falkenblog (which I found via Larry MacDonald’s Investment Ideas blog) captures the prevailing mood by arguing that the equity premium does not exist by making the following points:
- Geometric versus Arithmetic averages: I’m not entirely clear who the target of this criticism is. Almost every book I have uses geometric averages in talking about long-term market returns. Jeremy Siegel, for instance, clearly breaks out both geometric and arithmetic averages and his data indicates that stocks have exceeded bond returns by 3.3% during the 1802-2006 time period.
- Survivorship bias: I find it interesting that Falkenblog chose not to cite the Dimson, Marsh and Staunton paper, which found that equity premiums existed in every major market database for the 1900-2005 time period: “The annualized U.S. equity premium relative to bonds was 4.5% compared with 4.1% for the world ex-U.S. Across all 17 countries, the equity premium relative to bonds averaged 4.0%, and for the world index it was also 4.0%”. In other words, equity premiums are not unique to US stock markets.
- Taxes: Applying a tax rate on the equity premium is simplistic. A more careful analysis would apply past tax rates on returns from stocks and bonds and arrive at an after-tax risk premium.
- Adverse market timing and transaction costs: Many studies have established that the returns obtained by the average investor falls far short of market returns. However, intelligent investors who pay careful attention to expenses and emotions have high odds of outperforming all other asset classes by sticking with stocks over most long holding periods.
While the debate about past risk premiums may be interesting, a more pertinent question for investors is: where do we go from here? Today, 10-year bonds are yielding 3.5%. The dividend yield of the S&P 500 is about 2.5% and the TSX Composite roughly 3%. Stocks seem to be priced to deliver a healthy premium in the future even with very modest returns.