Equity Risk Premium

Sunday, February 26, 2006 | 11:45 AM

Why do stocks pay more than bonds? That’s the question a NYT column looks at this Sunday. Interestingly, why the risk premium is so high can have implications for the economy:

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You might think that the nation’s high priests of finance would have agreed by now on why stocks have paid much higher returns than bonds over the years.

You’d be wrong. But depending on whose explanation you believe, there are some important implications for the economy’s future. The outlook may not be so good, at least not for everyone.

As every first-year finance student knows, there is a not-easily-measurable number called the equity risk premium. Simply put, this premium is the extra return that stocks have to pay, because they’re riskier than safe government bonds, in order to attract investors. It’s the same reason that individual numbers on a roulette wheel pay more than odds or evens: higher risk, higher return.

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.

Some economists have suggested that the equity risk premium is reasonable, if you account for very rare but very costly events, like depressions and wars. But there is still much debate, and there are other explanations for the gap in returns.

I suspect its more than just Risk that accounts for the premium: Its complexity, its an individual’s lack of managerial competance vis a vis their investments. For most investors, Bonds are simply bought and held to maturity. Stocks, on the other hand, require far more oversight.

It is that ease of ownership that leads to increased demand forBonds — and their relatively lower returns:

Think about the two types of securities in terms of supply and demand. The market for safe government bonds includes investors who can’t buy stocks at all: foreign central banks, other government agencies, some institutional money managers and certain kinds of trusts. Moreover, financial planners may be too eager for their clients to buy safe government bonds. If their paychecks depended solely on whether their clients made or lost money, they might try to avoid losses at all costs.

In other words, it may just be ridiculously easy to raise money for bonds. Or investors’ expectations of stock returns may be irrationally low, focused more on crashes than booms. Either way, the equity risk premium wouldn’t explain the entire gap in returns.

We do know, though, that the risk premium must be some part of that gap. 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.

We’ll see if that turns out to be true soon enough.