What Risk Premium Is “Normal”?

The goal of this article is an estimate of the objective forward-looking U.S. equity risk premium relative to bonds through history—specifically, since 1802. For correct evaluation, such a complex topic requires several careful steps: To gauge the risk premium for stocks relative to bonds, we need an expected real stock return and an expected real bond return. To gauge the expected real bond return, we need both bond yields and an estimate of expected inflation through history. To gauge the expected real stock return, we need both stock dividend yields and an estimate of expected real dividend growth. Accordingly, we go through each of these steps. We demonstrate that the long-term forward-looking risk premium is nowhere near the level of the past; today, it may well be near zero, perhaps even negative. The investment management industry thrives on the expedient of forecasting the future by extrapolating the past. As a consequence, U.S. investors have grown accustomed to the idea that stocks “normally” produce an 8 percent real return and a 5 percent risk premium over bonds compounded annually over many decades. Why? Because long-term historical returns have been in this range with impressive consistency. Because investors see these same long-term historical numbers year after year, these expectations are now embedded in the collective psyche of the investment community. Both the 8 percent real return and the 5 percent risk premium assumptions are unrealistic in light of current market levels; more importantly, they have rarely been realistic in the past. As we demonstrate in this article, the long-term forward-looking risk premium is nowhere near the 5 percent level of the past; indeed, today, it may well be near zero, perhaps even negative. The goal of this article is to estimate the objective forward-looking equity risk premium relative to bonds through history. For correct evaluation, such a complex topic requires several careful steps: To gauge the risk premium for stocks relative to bonds, we need an expected real stock return and an expected real bond return. To gauge the expected real stock return, we need both stock dividend yields and an estimate of expected real dividend growth. To gauge the expected real bond return, we need both bond yields and an estimate of expected inflation through history. Accordingly, we go through each of these steps. We distinguish between observed historical return differences (that is, excess returns of the past) and the risk premium, which refers to expected future return differences. A critical component of our approach to the risk premium is to consider what investors could reasonably have been expecting at various points in the past. Using data from a variety of sources, we examine the history of U.S. bond returns, stock returns, return expectations, and economic, political/geopolitical, and demographic changes from 1802 to 2001. We draw the following conclusions: The observed real stock returns and the excess return for stocks relative to bonds in the past 75 years have been extraordinary, largely as a result of important nonrecurring developments. The investors of 75 years ago would not have had an objective basis for expecting the 8 percent real returns or 5 percent excess returns that stocks subsequently delivered. To shape future expectations based on extrapolating these lofty historical returns is dangerous. In so doing, an investor is tacitly assuming that valuation levels that have doubled, tripled, and quadrupled, relative to underlying earnings and dividends, can be expected to do so again. The real internal growth that companies have generated for nearly 200 years in dividends and earnings is slower than the increase in real per capita GDP. This internal growth is far less than the consensus expectations for future earnings and dividend growth. The historical average equity risk premium, measured relative to 10-year government bonds, that investors might objectively have expected on their equity investments, is about 2.4 percent. The consensus that a normal risk premium is about 5 percent was shaped by deeply rooted naivete in the investment community, where most participants have a career span reaching no farther back than the monumental 25-year bull market of 1975-1999. This kind of mind-set is a mirror image of the attitudes of the chronically bearish veterans of the 1930s. Today, investors are loathe to recall that the real total returns on stocks were negative for most 10-year spans during the two decades from 1963 to 1983 or that the excess return of stocks relative to long bonds was negative as recently as 10 years ago. When reminded of such experiences, today's investors tend to retreat behind the mantra “things will be different this time. ” No one, however, can kneel before the notion of the long run and at the same time deny that past circumstances will again occur in the decades ahead. Indeed, such crises are more probable than most of us would like to believe. Investors naive enough to expect a 5 percent risk premium and to sharply overweight equities accordingly may well be doomed to deep disappointments in the future.