A Puzzling Tale

A Puzzling Tale

“The Case for Bonds in 2040″

When I graduated from business school in 1981, the investment world was entering what I call its quantitative phase.  Today, we are in full quantitative bloom and like many evolutionary processes, 30 years later we see the models of that time, which means the thinking of that time, left out the qualitative or behavioral components.  As much as portfolio researchers tried to develop models that captured the relationships between investments they couldn’t quite get it right.   Empirically, we can see that markets or prices don’t behave the way the models predicted.  This is not a criticism of the models, their development was necessary to get us to this phase.  Out of this quantitative model meets reality conundrum has arisen new thinking in what multidisciplinary researchers call complexity theory.  In my opinion, complexity is the new investment frontier.  These tales are meant to be evergreen so I hope years from now when I and others read this tale that Complexity, in particular, the study of Complex Adaptive Systems or CAS was in fact the next frontier.  But this is A Puzzling Tale and so we will only deal with one complex issue at a time.  If you want more on complexity read A Complex Tale.

This tale deals with asset pricing – a very complex topic.  No discussion of equity pricing can be complete unless you compare it to something else, so we will compare it to what is generally agreed is the safest instrument known at this time, what financial researchers call the risk free rate of return or the short term US Government Bond.  In particular this tale deals with what researchers call The Equity Premium Puzzle or EPP.  Let’s take it one step at a time and define it.  The Equity Premium is a variable that measures the amount of Equity Premium or Risk Premium that an investor requires in order to invest their money in equities instead of the riskless bond alternative.  This is a simple concept that deals with choices, you either open door A or door B.  Ask the following question and you will understand the Equity Premium.  If I have $1 in my hand and I can buy either a riskless investment that is guaranteed to give me my $1 back plus some interest, how much more must I expect to make in order to choose the riskier alternative?  The difference is the Equity Premium and it attempts to measure the risk of equities.  It is an equalizer between safety and risk.  It seems simple but when you read more you will see why it is so complex.

So what is the The Equity Premium Puzzle?  The EPP was first introduced in 1985 by two very smart economists Rajnish Mehra and Edward Prescott and asked a simple question.  Could the world, meaning other researchers, please explain why investors want such a high equity premium in order to invest in equities?  What the question was asking at the time was subtle.  They wanted to know why stocks made investors so much more money than bonds.  Are investors so risk averse that they require implausibly high premiums to assume risk?  The high differential didn’t make sense to these two fellows.  There had to be an explanation.  Unfortunately, to this day there are no explanations.  There are theories but no resolution.  This tale does not offer a resolution since I don’t believe there is one but provides insight on how investors need to think about equities vs. bonds.  Lately, and at the extreme, some even go so far as to suggest that there is no Equity Premium whatsoever since equities and bonds have performed approximately the same over approximately the last 30 years.

Let’s go back to 1985 when things were different.  A time when equities had significantly outperformed their riskless bond competition over the previous century and it appeared that the high differential would persist.  The Equity Premium or differential became a given, a truth, a belief, a mantra, a fact of life.  Since stocks had outperformed bonds by approximately 5-7% over the last century, depending on whether you used an arithmetic or geometric average and depending on what time frame was measured, they would of course continue to outperform into the future or as economist like to say, the long run.  Every financial planner knew it.  Every investment advisor knew it.  Every financial publication knew it.  It became the cornerstone of Modern Portfolio Theory.  People won Nobel Prizes for it.  Every portfolio construction had as its underlying truth the fact that equities outperform bonds because they are riskier.  They were all wrong, at least over the last 30 years.  Stocks and bonds have performed the same over the last 30 years.  There has been no equity premium.

Let’s go to the present, it is now 2010 and we are all left scratching our heads.  In retrospect the implausibly high differential question that Mehra and Prescott asked proved to be—-you guessed it—–implausibly high.  But an Equity Premium surely must exist.  It is intellectually sound.  However, it’s magnitude and over what time frame is anyone’s guess.  Personally, I refuse to believe that stocks and bonds perform the same into perpetuity.  Stocks must outperform bonds into perpetuity because people must be compensated to take risk.  However, investors don’t live forever, so the concept of perpetuity is meaningless for all practical purposes.  Let me say it one more time.  The concept that stocks will outperform bonds over time is meaningless to anyone or any organization that doesn’t have a perpetual time frame.  This is not a comforting thought for investors that struggle with the where to put $1 decision every day.  So the real question investors must ask is not will stocks outperform bonds over time but will they outperform over the required time frame.  The answer is nobody knows and as we have learned throughout these tales, defining the required time frame is no easy task either.  Time frames change and objectives change.  Is it any wonder that investors seek guidance?

Let’s take this to the last logical step.  I like thought experiments so, let’s go forward 30 years to the year 2040 and examine the EPP.  As we know, the expected rate of return between stocks and bonds is the center of the investment decision.  So let’s examine a discussion with your advisor that determines where to invest your $1.  Remember, he or she has no idea what the future holds over your investment lifetime, together you are simply making an educated decision.  In this case let’s say that your advisor is trying to sell you a product that assumes the equity premium will be small, narrow or even negative over the life of the investment.  This means that over the life of the investment, you are hoping bonds will return approximately the same or even better than stocks.  What evidence will he or she bring forward to convince you?

Let’s look at the results from 1980-2010 as a base.  Stocks and bonds have in fact returned approximately 9% each over the last 30 years.  The following table will give a pretty good range of what investors will face in terms of solving the EPP 30 years from now.  The table assumes that stocks will earn 9% over the next 30 years and varies the return on bonds over the next 30 years.  The results and how investors will look at where to invest based on history in the year 2040 is very interesting and a good thought experiment.

The Equity Premium Puzzle Table

 

If Bonds return X% from 2010-2040	0.0%	1.0%	2.0%	3.0%	4.0%	5.0%	6.0%	7.0%	8.0%	9.0%
The Equity Premium from 1980-2040 is	4.5%	4.0%	3.5%	3.0%	2.5%	2.0%	1.5%	1.0%	0.5%	0.0%

As we can see from the table, 30 years from now, it is highly unlikely that the Equity Premium will approach what researchers saw in 1985.  Let’s analyze what happens to the bond sales pitch if bonds earn 4% over the next 30 years.  We can see that the bond or annuity salesman will be looking at the investor in the year 2040 and saying, “You know that stocks have only outperformed bonds by 2.5% over the last 60 years.  Why on earth would you want to allocate any money to an asset class where you can lose 50% of your money if you start at the wrong time?  The risks aren’t worth it.  Do you know that if you started at the wrong time in 1987, 2000, 2007, 20XX and 20YY you would have lost more than 25% on your money within a few months? You know the evidence is in.  Stocks aren’t worth the risk.”

I love this bond hypothetical example that analyzes the 1980-2040, period because it will have 60 years of data to analyze.  This same 60 years or the “Long Run” is about the same number of years that the early quantitative researchers or quants had when they developed the models that to this day manage most of the money in America.

Some lessons to learn form this tale and apply right away.

1)      The “Long Run” is meaningless to an individual investor.  The individual investor does not live in the “Long Run” but in the “Short Run” which in this case I define as the investor’s horizon.  Where you put your $1 today should be based on your set of circumstances not a general or average set of circumstances.  For example, the idea today 2010 that bonds are a good investment when they yield less than ½% compared to owning a diversified portfolio of high dividend paying stocks that yield approximately 3.5% is silly.  Yes, the last 30 years might suggest that stocks and bonds perform equally, which would tell us to invest in bonds.   But in my opinion that would be a mistake.  Read An Old Timers Tale to see why.  I would rather collect my 3.5% with an opportunity for dividend growth and live through the periods of stock market fluctuation than be stuck holding a low yielding investment with virtually no chance of capital appreciation at this time.

As proof I offer up what I call PIMCO evidence.  For those that do not know the name, PIMCO is the largest and most successful bond money management firm in the world.  They are it.  The Babe Ruth of bonds.  What are they doing as I write this tale?  They are devoting serious resources to implementing a stock component to their bond money management business because they know bonds are in trouble over the next many years.  They are not dead but they don’t hold the promise they once did.

2)      There is no correct answer to the equity premium puzzle.  It is a moving target based on complex circumstances.  While there is no doubt that investors must expect to receive a higher return if they invest in a riskier asset, who cares if it doesn’t work for their set of circumstances.  They are asking the wrong question.  Focus on what matters to you.

3)      I can’t think of another time in history where investors have faced such tough choices as they do today.  If they invest safely they are getting virtually 0% on their money.  If they take some equity risk they can lose a substantial amount very quickly.

Let me close by saying that I think the Class A share common stock in developed nations is suffering and investors inherently know it.  I would not be surprised if by 2040 we have evolved a new security that has some of the characteristics of the old style or nostalgic ownership that we once associated with owning common stock.  Warren Buffett would describe a common stock as having ownership in a business.  I’m not so sure that definition is as true today as it use to be.  Said perhaps differently, ownership isn’t what it use to be.  I think many factors have made ownership on a claim on future earnings less desirable than in the past.  The yet to be developed security of 2040 which will be competing with the bond and annuity salesman of that time will be largely free from litigation risk that can take a company such as BP and bring it to it’s knees.  This new security will also find a way to distinguish and compensate those executives that produce results vs. those that catch a bull market wave and appear competent while not adding value.  For those that are interested in reading more on this they can read A Common Tale.

Home / Author Bio / Financial Tales / Resources / White Papers

Stay Informed – Help Promote Financial Literacy