The Risk Premium

To say that the risk premium is the difference between the return on stocks and the return on bonds is assuming that markets are constantly in equilibrium. This is not always true. In fact (to rehash an old handout) in the NYT from 2006, there’s an article by Daniel Altman which says,

For decades, the returns on stocks have usually been much higher, relative to bonds, than risk alone would seem to justify — perhaps as much as six or seven percentage points higher. If risk were the only explanation, the difference would suggest that investors were extremely risk-averse, to the point that they would never leave the house for fear  of having to cross the street. [link]

Nevertheless, despite short-term blips (both, up and down) in the risk premium, long-term studies have shown that it is mean-reverting or constantly tending towards a steady average. Later, in that same article,

According to research by William N. Goetzmann and Robert G. Ibbotson, two finance professors at Yale, that premium has stayed fairly constant over long periods through virtually all of American history. For lack of a better reason, there may just be something special about American capital markets, so that a high equity premium would tend to revert to some sort of long-run average. In other words, the equity premium may be a partial predictor of future stock returns and even the future growth of the economy. [link]

[I’ve uploaded the paper to my server, if you’re interested in venturing into the realms of technical econ reading]

I blogged about this earlier, but interestingly enough, because the current (narrowly averted?) financial crisis had so much to do with debt and debt-related instruments (like bonds), it put a whole new spin on the risk premium – these instruments became riskier and less liquid than stocks. So what do you think happens to the risk premium when the return on bonds falls below the return on stocks? When bonds become riskier than stocks? Read more.

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2 comments for “The Risk Premium

  1. July 2, 2008 at 10:45 pm

    Constructivist Modeling and the Equity Premium Puzzle

    I’ve been thinking more about why some investors put money in bonds instead of stocks despite the far superior return rate of stocks. I’ve come up with some hypotheticals that helped bring me closer to an answer.

    Let’s say I’m a trillionaire (wahoo!). I then decide to invest a paltry $1 million into a stock. Sure, it may be a particularly risky stock, maybe even has a 90% chance of decreasing in value–but who cares. I’m a trillionaire!

    Next, let’s imagine I’m someone who earns $30,000 a year and have $5,000 in savings. Even if I’m 90% sure a stock is going to go up in value, I might just stick to some federally insured bonds. This is because my risk aversion is determined by my own wealth and the size of possible investment I’m making in proportion to that wealth, not by some risk factor that can be determined independent of my relationship to it.

    Which is where constructivist thinking comes in–that truth is created as a relationship between things, not as facts free-floating in the world. Similarly, the risk premium of a stock is relational; it results through a relationship between the stock and the investor, and is primarily determined by the scale of risk in proportion to the assets of the investor and the size of the investment.

    The idea of risk is largely meaningless without knowing the economic actor who is taking that risk, for the exact same share of the exact same stock can be far riskier for the poor than the rich.

  2. July 3, 2008 at 9:42 am

    Agreed, but as we move the lens further and further out, different patterns emerge out of the noise. Are they determined by individuals? Yes. Can we blur that line between individuals? Maybe, maybe not. But that’s what we have to do when talking about macro concepts. It’s crude, but whether or not it’s effective – you be the judge.

    The differences between macro and micro become quite stark at times.

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