So Long Valhalla,

Hello Risk Premium

What a difference a few measly years can make. Twenty-one short months ago, the tantalizing prospect of technology-driven global prosperity stretched endlessly to the horizon. But early in 2000, the dream slowly started to sour. At first, it was an abstract affair: investors finally began doing the math. And when they did, they found we had built more chip, fiber-optic, and even automobile capacity than could be consumed. They also realized that corporate earnings might not grow to the sky in industries operating under Hobbsean competition and 100 to 1000% oversupply. (In the infelicitous jargon of the dismal scientists, malinvestment.) As so often happens, these early losses awakened the investing public to something called risk. With that awareness, investors began to discount future earnings and dividends at ever higher rates, lowering prices still further.

The other shoe dropped on September 11. The world found out, in one murderous paroxysm, that history had in fact not ended, that ancient religious and not-so-ancient ideological fissures had not healed, and that the human race had yet to become one big happy family.

Suddenly, it looks like the bad old days again. Let’s step back and take a glance at where we’ve been and where we’re going. Here’s the take-home cartoon:

	1999	2001
Expected Risk Premium	Zero	Average
Realized Returns	High	Low

During the heady days of 1999, the world was a wonderful place. You did not have to be a genius to earn high returns; you simply sent a check to Valley Forge or Boston, or less reliably, placed a call to your broker.

But anyone able to add could catch a glimpse of grimmer times ahead. The long-term real growth of earnings and dividends had not budged from the historic 2% rate, and stock yields barely poked above 1%. A future of 3% real expected returns beckoned. At the same time, real T-bill yields were also about 3%. Thus, two years ago the expected risk premium was zero. "This was just as things should be," said the optimists—in the long term, stocks weren’t risky at all; thus they should command no premium. (To swallow this you also had to believe that the average investor actually knew the difference between a risk premium and a cheese blintz.)

Fast forward two years. Chopping 30% off equity prices has adjusted dividends, and thus expected stock returns, upward by 70 or so basis points; this gets us to almost a real 4% return. From the perspective of earnings, things look better. The earnings yield also provides a good approximation of real expected returns: now about 4.5% for the S&P 500, 5.5% for foreign stocks, and perhaps higher for value stocks. Let’s be conservative and simply estimate real expected returns at 4.5%. The current real riskless rate? Exactly zero. (My friend Steve Dunn will argue that the new risk-free asset is the TIPS, with a 3.4% yield. Perhaps, but most investors do not put a significant portion of their portfolio in these vehicles. Only sophisticated folks who also have large amounts of tax-sheltered assets.)

Suddenly, we’re looking at an expected risk premium of 4.5%. Not because stocks have gotten so much cheaper but because safety has gotten so much dearer. This is very similar to what the world looked like after 1960. But consider the state of the planet in June 1940, with Hitler staring at Dover through binoculars and the Soviet Union and the U.S. on the sidelines. A little more than a year later, Guderian would be doing the same at Moscow, and the pride of the U.S. Navy would be resting at the bottom of Pearl Harbor. T-bill yields? Close to zero. (Through a mathematical quirk, academicians calculate the T-bill rate for 1940 at minus 0.02%). Stocks yielded an incredible 7%, for an expected real return and calculated equity risk premium of 9%. The expected risk premium fell slowly from there, hovering at around 5% throughout most of the Cold War.

An expected risk premium of 4.5% seems about right for our times. Our parents and grandparents had to deal with Adolph Hitler and Joseph Stalin. Bin Laden's a very bad actor indeed, but not in the same league with our parents' bogeymen. I’ll take the current state of the world, over that of 1940 or even 1950 with its big fat 9% equity risk premium, any day of the week.

In the below figure, I’ve plotted the expected risk premium over the past 70 years.

This plot is a dicey undertaking since it rests on a number of strong assumptions. The expected risk premium is calculated as the difference between the expected real return of stocks (which I define as the dividend yield of stocks plus 2%) and the real T-bill yield. Since inflation rates can be quite volatile, these are smoothed over five years. The plot is also hostage to the vagaries of inflation: The calculated expected risk premium in the early 1930s is lower than it would otherwise be because inflation was strongly negative, producing high real T-bill returns, even though nominal T-bill yields were near zero. And the equity risk premium is artifactually higher in the late 1940s for the opposite reason. Lastly, the near 5% current expected risk premium doesn’t make it into the graph because of five-year smoothing.

As can plainly be seen, the expected risk premium declined from stratospheric levels to zero in the last half of the 20th century. Just as interest rates are a kind of societal "fever curve," so too is the expected risk premium.

So, welcome back to the future: the world of our fathers, with high risk premia and low risk-free rates. It’s a more uncertain place than it used to be, but at least you’ll be rewarded for shouldering that uncertainty.

Copyright © 2002, William J. Bernstein. All rights reserved.

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