What Equity Premium?

One of the fundamental tenants of finance is that stocks do better than bonds over the long haul. The difference is known as the equity risk premium. In other words, it’s the amount that investors are paid to take on the extra risk of owning stocks. (Small but important note: the equity risk premium most often refers to the gain stocks have over short-term T-bills, in this article I’m referring to the gain stocks have over long-term government and corporate bonds.)
The reason for the equity risk premium has puzzled economists for a long time. In fact, Jim Glassman and Kevin Hassett went so far as to say that it shouldn’t exist, and that’s how they got their Dow 36,000 hypothesis. I did some data-crunching today to add in the market’s recent performance and found that there really hasn’t been much of a premium for a long time. So were Glassman and Hassett correct in their theory except the wrote the book 20 years too late?? (Well, no…but I’ll get to that).
The best source for long-term investment information is Ibbotson Associates, now a part of Morningstar. Each year, Ibbotson releases its yearbook for historical returns of stocks, bonds, bills and inflation going back to 1926. I often refer to their work on this blog.
From the end of 1968 to the end of 2007, stocks’ advantage over bonds has been quite modest. Over 39 years, stocks have basically doubled both Treasuries and corporates. Doubling in 39 years may sound nice, but it really isn’t that impressive. It works to about 1.85% a year for corporate bonds and 1.89% for government bonds. Given how much more volatile stocks are, I don’t think you’re being paid a lot.
Since 2008 has been a horrible year for stocks, I was curious how these data sets have changes. I called Ibbotson but unfortunately, they don’t do any mid-year updates. So I want to see if I could find a reasonable estimate. Obviously using different data sources can alter your results, but I was looking for data that’s broadly considered fair.
For the S&P 500, Ibbotson uses the dividend reinvested S&P 500. For the first three quarters of 2008, that index is down 19.3%. For corporate bonds, they use Citigroup’s Long-Term High-Grade Corporate Bond Index and for the government bond, they use the 6.375 Treasury that matures in August 2027 (I assume they’ll use a 2028 bond for this year). I couldn’t find the stats on either of these that but I called Vanguard to see how some of their index funds were doing.
The Vanguard Long-Term Investment-Grade (VWESX) fund is down 7.39% this year, and the Vanguard Long-Term U.S. Treasury (VUSTX) is up 6.69% this year. I think both of these funds can serve as proxies (VWESX has a current yield of 6.69%, an average rating of A1 and an average maturity of 22.5 years; VUSTX has a yield of 3.86% and an average maturity of 17.5 years).
Tacking these numbers onto the data series, that makes the 39.75-year advantage stocks have over corporate bonds just 1.50%, and only 1.10% for government bonds. If we do a little data picking, we can see that long-term Treasury bonds have outperformed stocks since the summer of 1987, and come in just behind stocks since late 1980. Reasonable people can disagree but that certainly sounds like the long-term to me. This means that you could have sat out the entire stock market over the last 28 years, parked your money in long-term T-bonds and done just as well as the stock market, which we know beats the vast majority of fund managers.

Posted by on October 6th, 2008 at 2:52 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.