The Shrinking Equity Premium and What It Means to Investors

    by Paula Hogan

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    In every walk of life, there are periodic debates about norms, from physicists deciding how the universe began to parents debating how to get an infant to sleep through the night. These debates help form our notion of what is correct and normal and lay the foundation for our perception of what to expect in the future.

    Financial economists—the academics who study financial markets and human investment behavior and who in large part form our notion of what is normal in the world of investments—are now engaged in such a debate, a debate that is beginning to be covered in the popular press. Consequently we may be in the midst of a cultural change in our notion of what is normal in the world of investments.

    The debate centers on the estimate of the equity premium, which measures the excess return of stocks over the return offered by risk-free assets—how much higher a return we may expect, on average, from stocks than from U.S. Treasuries. In other words, it measures the compensation for the risk of being an owner.

    Investors’ notions about the equity premium, including what it has been and what it will be, influences every important investment decision. Individual investors base assumptions about how much to save in order to meet long-term goals, such as college or retirement funding, by implicitly referencing the equity premium. The higher the equity premium, the better the returns you expect from your portfolio, and hence the fewer the dollars you need to invest in order to meet future financial goals.

    Traditional Estimates

    The traditional estimate of the equity premium comes from an evaluation of market data covering the U.S. markets since 1926 by Ibbotson Associates. Ibbotson data is described in finance textbooks in every business school and so, not surprisingly, it is the benchmark routinely referenced by corporate executives throughout the land.

    As a result, investors tend to think of stocks as having an average annual nominal return since 1926 of about 10% to 12%, which is composed of a 3% to 4% risk-free Treasury-bill rate, plus a 7% to 8% equity premium. More importantly, investors tend to think that these estimates are reasonable to use when planning for the future as a forward-looking estimate of return.

    For the investing public, this estimate of the equity premium has led to wide acceptance of the notion that “you can’t lose with stocks, stocks always beat bonds over the long term,” and that portfolios with long time horizons should have high stock allocations.

    In contrast, in the academic world, there is an emerging consensus that the equity premium looking forward from here is significantly less than the 7% to 8% traditional consensus estimate. The debate within the academic community is how much to lower the equity premium estimate—with far-ranging consequences for individual investors. The range of estimates for the equity premium tops out at under 5%, with many researchers promoting a 2% to 4% estimate. This implies a 5% to 7% annual future return for an all-stock portfolio.

    That the equity premium is shrinking may not be a startling prediction to perspicacious individual investors. For older investors who remember stock markets other than just the recent roaring bull market, and for those who have studied the history of the stock market, the idea that relative stock market performance will likely cool off in the next few decades is not shocking. But younger investors whose only investment experience is the recent powerful bull market may be surprised by a shrinking equity premium, and even feel that the world is changing around them as the risk/reward character of stock investing changes. Of course, the most recent bear market over the last year or so may also be changing some investors’ minds.

    The Shrinking Premium

    Financial economists, however, use rigorous economic analysis to support the premise that the forward-looking equity premium is substantially lower than originally thought. Key threads in the academic debate include:

    • Once research includes data from before 1926 and from countries beyond our own, the historical premium shrinks; and

    • The forward-looking premium is even lower than the revised historical premium estimate once you factor in the impact of the historically high market valuations that were in place recently. According to this argument, history, theory and simple math all suggest that when markets start a decade with high valuations (as is reflected by the historically high price-earnings ratios applicable as recently as a half year ago), future stock returns will be relatively low—even for those with a long time horizon.
    There are also plausible economic arguments explaining why a lower premium now makes sense. For example, the past high premium may have been in large part extra compensation for stock investors that was necessary before the economy developed to its current state of efficiency, before investors had access to the low-cost diversified portfolios that are possible with modern mutual funds.

    Financial economists thus come to the same conclusions as those of the perspicacious individual investor: That the forward-looking equity premium is substantially below the currently accepted norm; and, stocks are not likely to outperform government securities in the future by as wide a margin as they have in the recent past.

    As an aside, economists Robert D. Arnott and Ronald J. Ryan, in their article “The Death of the Risk Premium” (which appeared in the Spring 2001 Journal of Portfolio Management and was winner of this year’s prestigious Bernstein Fabozzi/Jacobs Levy Outstanding Article Award), point out that stocks have not always produced an excess return: For example, “from the end of 1961, an investment in Treasury bills outpaced both stocks and bonds through mid-1982, a span of 20-plus years. From the 1929 market peak, stocks underperformed bonds over the subsequent 17 years and needed 25 years to outpace Treasury bills. For the investor in 1801, by some measures, stocks merely matched bonds over the subsequent 70 years.”

    What It Means

    So what does it mean for you if the equity premium is shrinking? Has your investing world changed? Do you need a new investment plan? As reports of “the death of the equity premium” reach the retail press, do you need to be worried?

    The answer is that you do not need a new investment plan, but you may need to update expectations and your habits of financial thinking.

    Despite a shrinking equity premium, the world has not changed:

    • There is no paradigm shift,
    • Stocks are still the asset class with the highest expected return, and
    • Over the long term, you can still expect of make more money as an owner, not a creditor—as a stock, not a bond, investor.
    What has changed is that the expected payoff of being an owner is less than it has been in recent years. As the equity premium shrinks, expect to see a renewed interest in adequate savings rates and insurance protection, as well as in excellent portfolio diversification and cost control. There will also be less social pressure to feel that you are somehow inadequate if you don’t invest a higher percentage of your portfolio in the hot stocks of the day.

    If you are an individual investor funding your own retirement and the equity premium has shrunk, the required savings rate to meet your goals will be higher than estimated several years ago. As this idea ripples through the economy, expect to see a renewed respect for saving and less confidence that good portfolio returns alone will take you where you want to go.

    The shift in the risk/reward characteristics of stocks also makes diversified portfolio strategies newly appealing, as well as prudent. It’s safer and easier to hold a stock/bond blend portfolio instead of an all-stock portfolio when the relative performance of stocks and bonds is closer together.

    During the bull market, as investors became increasingly comfortable holding stocks, the “normal” portfolio allocation for many investors slid up from a pre-bull market norm of 55% stocks/45% bonds to an 80% or even higher stock allocation. As the idea of the lowered equity premium becomes more accepted, however, expect the default portfolio allocation—for example, as assumed by the retail press—to gradually move back towards the traditional 55% level.

    Similarly, the default “sustainable” portfolio withdrawal rate—the amount you can safely withdraw each year from a retirement portfolio without outliving your assets—will likely shift downward, perhaps to about 3% to 4%. Buying annuities and triggering lifetime supplemental income in retirement will become more popular, and with good reason, especially if the annuities are purchased from firms that direct excess reserves to still-living annuitants, not shareholders. (Excess reserves arise when annuitants die before their life expectancy.) In this light, triggering annuity income becomes almost an insurance approach to protecting lifetime income, for example, as are in essence defined-benefit pension plans. One recent study estimates that savings can be 23% less if funds are pooled across pensioners instead of being saved individually, such as in 401(k) accounts. Consequently, expect to hear more discussion of defined-benefit pension plans provided by corporate America, as well as other insurance approaches to protecting lifetime income, such as long-term care insurance.

    In this context, the rational investor will make modest fine-tuning adjustments to portfolio allocations, will continue to pay close attention to portfolio costs and savings rates, and will explore opportunities for insurance protection. In this way, the individual will be able to incorporate lowered expectations about future portfolio returns into daily life.

    Behavioral Aspects

    But investors are human, not simply rational beings. Behavioral economists predict that particular human tendencies might confound a smooth transition to a lower equity premium.

    For example, investors typically place disproportionate value on recent personal experience. However, we now have a whole generation of investors who have experienced primarily a very strong bull market.

    Accepting a lowered equity premium means making a conscious wrench away from the comfortable habit of using the immediate past as a guide for the future.

    As stocks shift away from being, with a high degree of probability, a relative very-high performing asset, investors may fall prey to a common simplifying strategy: Treating low probability events as really certain not to occur, and events with a high but not certain probability as close to certain to occur. This strategy is at best uncomfortable when either low probability events occur, or when probabilities change.

    Investors also tend to benchmark events to their own immediate world and strive to minimize regret. For example, a rational investor knows that, absent extreme market conditions, in a well-diversified portfolio, some investments will go up and some down. Further, it doesn’t matter much which assets move up or down, only that there are definitive cross-currents within the portfolio in most time periods. In other words, the rational investor knows that the goal of diversification is to muffle return volatility, improve downside risk protection, and therefore lower risk and increase long-term total return.

    In practice, however, most diversified investors actually feel better when their portfolio outperforms their benchmark, which is typically set to the performance of large-company stocks in their own country. So, when U.S. stocks underperform international stocks, internationally diversified U.S. investors tend to feel good—while at the same time internationally diversified investors abroad struggle with regret.

    Understanding this propensity to benchmark to one’s own world, and our love of minimizing regret, is important protection for investors. And turning up one’s skill as a realistic, diversified—and insured—investor is even more important with a shrinking equity premium.

    In sum, the world hasn’t changed, but life is moving on. And those who adapt will tend to come out all right.

    Paula Hogan, CFP, CFA, is the founder of Hogan Financial Management, a comprehensive fee-only planning firm based in Milwaukee, Wisconsin. She also maintains a Web site at

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