I have posted Podcast #162 to the “RobCasts” section of the site. It’s called I Was Wrong: There Is No Equity Risk Premium.
The conventional idea is that stock returns are determined by market forces, that stock investors are being compensated for their willingness to take on risk. No. Stock returns are determined by economic realities — it is the productivity of the U.S. economy that determines the long-term stock return. There is no dickering involved here. Stock investors would be paid the same long-term return whether they were willing to take on risk or not. Or at least so says Rob Bennett in October of 2009.
Evidence Based Investing says
Corporate bond returns are also determined by economic realities. And yet bond returns have been lower than stock returns. The reason for this is risk.
Bond holders are ahead of stock holders for their claim on corporate earnings. Hence stocks are riskier.
Bond holders have a claim on the first dollar of profits that a corporation makes. It is only if a corporation makes money in excess of that which is required to service their debt that stock holders can expect a reward.
The fact that you don’t seem able to grasp the relationship between risk and reward is puzzling. You claim to have read Bill Bernstein’s book “Four Pillars of Investing” which explains this very well. And yet you still don’t get it.
Maybe this comes down to you rereading parts of the book multiple times and reading other parts just once.
You really should make more effort to learn about those areas of investing that you don’t understand.
Rob says
You really should make more effort to learn about those areas of investing that you don’t understand.
I am grateful to you for taking time out of your day to share your thoughts with us, Evidence. I would be even more grateful if you could rein in the attitude. It detracts from the learning experience of all community members (including you!).
You say that I “don’t understand.” Perhaps you’re right. Perhaps you’re wrong. If you make your case effectively, you will persuade others (and perhaps me too!) that I do not understand without having to cop the oh-so-superior attitude that is such a turn-off to reasonable people.
My take is that none of us understand it all perfectly and that we all should be working hard to understand better. There are things that you don’t understand and there are things that I don’t understand. Let’s put our minds together and get about the business of enhancing our mutual understanding.
Maybe this comes down to you rereading parts of the book multiple times and reading other parts just once.
There’s not question but that this is a factor. My take on the Four Pillars book is that it is part genius and part gibberish. I am obviously more drawn to the parts in which I find genius than to the parts in which I find gibberish. Are you so different? You’re drawn to different parts of the book. But you too pay more attention to the parts that make sense to you than you do to the parts that from your perspective do not make sense.
Corporate bond returns are also determined by economic realities.
I question this.
The return on a bond is determined by the corporate officers at the time the bond is issued. The corporate officers are influenced by market considerations (to sell the bond they need to offer what potential buyers will view as “a good deal”). Certainly there are expectations of economic realities that come into play. The buyers demand compensation for the risks they believe they are taking on. But what if their perceptions are wrong? in that event, they are not obtaining proper compensation for the risks that exist in reality.
It doesn’t work this way with stocks. With stocks, there is no market that sets the long-term return. The long term return is set solely by the economic realities. U.S. productivity justifies a long-term return of 6.5 percent real and that is what stock investors obtain (after the necessary adjustments are made for the effect of valuations).
With stocks, there is something real setting the price. With bonds, it is perceptions of something real that set the price. I am coming to see that as an important distinction (but my thinking re this question is tentative, to be sure).
And yet bond returns have been lower than stock returns. The reason for this is risk.
I don’t think risk (my reference here is to real risk, not perceived risk — perceptions of risk play a role, as described below) has anything to do with it. I of course understand that this is the conventional thinking. And there was a time when I bought into it. I am having very serious doubts about this today. I want to hear more smart people comment on the new ideas before I take a more confident position re them.
I am saying that owners of index funds are being paid a share of U.S. productivity. Period. RIsk has precisely zero to do with it, according to this line of thought (I am of course happy to be challenged re this point — I am not God and I am not necessarily right about this).
I think that perceptionsof risk are what set bond returns. If the stock return is fixed by U.S. productivity and if stocks are perceived as more risky than bonds, it certainly makes sense that bond returns would be set by the corporate executives (who are responsive to market demands) lower than the long-term valuation-adjusted return being paid by stocks.
I am saying that stocks are going to pay 6.5 percent real regardless of how risky they are. It simply makes no difference. I believe that we have made stock investing far more risky than it needs to be by encouraging a belief in Passive Investing. That hasn’t changed the return. It is still 6.5. If we shifted to Rational Investing, that wouldn’t change the return either.
It would change volatility. If we did away with the Passive concept, stock prices would self-regulate. The P/E10 level would always be about 14 and the annual return would always be about 6.5 real. Risk would be greatly diminished in such a world, but the stock return would not be diminished at all. It is U.S. productivity that sets the stock return (according to this line of thought).
Bond holders have a claim on the first dollar of profits that a corporation makes. It is only if a corporation makes money in excess of that which is required to service their debt that stock holders can expect a reward.
This is so. But I am not talking about the return paid by any one company’s stock. I am talking about the return paid by ownership of a broad index fund. What do you think the chances are that the long-term profitability of the entire U.S. economy is going to decline to zero? I think it would be fair to say that that is the longest of long shots. So long as the U.S. economy remains roughly as productive as it has been in the past, this benefit for bondholders is of no significant consequence to owners of shares in broad index funds.
One of the problems we are dealing with is that the conventional wisdom was developed in the days before index funds. Bogle brought on a revolution in investing when he popularized the indexing concept. The realities for indexers are very different than the realities for owners of shares in individual companies. Too little attention has been paid to this thus far, in my assessment.
The fact that you don’t seem able to grasp the relationship between risk and reward is puzzling. You claim to have read Bill Bernstein’s book “Four Pillars of Investing” which explains this very well. And yet you still don’t get it.
The way that I would say it is that I “get” the conventional wisdom in that I understand the claims being made. But I have noticed that these claims do not stand up to scrutiny. So I do not buy the conventional wisdom. I reject it.
I am of course grateful for Bernstein’s help in bringing me to a better understanding of the realities. I certainly could not have done what I have done without him. But I don’t think he is incapable of error. I view it as silly in the extreme for anyone to entertain such an idea. He’s human. He’s flawed. He got some stuff right and he got some stuff wrong. Chapter Two is a masterpiece, in my assessment. Other chapters leave a good deal to be desired, in my assessment.
Rob
Evidence Based Investing says
There are many flaws in your response, I’ll concentrate on one.
If we did away with the Passive concept, stock prices would self-regulate. The P/E10 level would always be about 14 and the annual return would always be about 6.5 real. Risk would be greatly diminished in such a world, but the stock return would not be diminished at all.
Let’s suppose that this completely unrealistic scenario did happen. Why would any investor settle for 1% real return in low risk assets like short term bonds when they could get 6.5% real return in stocks where “Risk would be greatly diminished”.
In such a world there would be a huge movement of money from low return assets like bonds to high return assets like stocks. This would drive up the price of stocks and lower their return.
Rob says
Let’s suppose that this completely unrealistic scenario did happen.
If we open the internet up to honest posting on investing, it happens, Evidence. We have seen thousands in the Retire Early and Indexing communities express a desire to learn the realities of stock investing. That translates into millions in the world at large. When people learn that they can obtain higher returns at reduced risk, there is no motivation for them to invest passively. Free speech overcomes ignorance.
Even The Stock-Selling Industry benefits in the long run from the transition to the Rational model. We all benefit from having a more stable and more productive economy.
Why would any investor settle for 1% real return in low risk assets like short term bonds when they could get 6.5% real return in stocks where “Risk would be greatly diminished”.
Your point here is well taken, in my assessment.
In such a world there would be a huge movement of money from low return assets like bonds to high return assets like stocks. This would drive up the price of stocks and lower their return.
Not if honest discussion of the realities of stock investing is permitted on the internet. In a world in which we permit discussion of the realities of stock investing, stock returns are self-regulating. Any increase in the return above 6.5 real causes sales, which bring about lower returns. That’s so. But any drop in the return below 6.5 causes buys, which bring about higher returns. In a world in which honest posting is permitted, market forces will always cause the return paid by stocks to be in line with the return justified by the economic realities — 6.5 real.
You are right that the market will not permit the return on non-stock asset classes to remain far below that of stocks in a world in which the riskiness of stock has been greatly diminished. But the stock return will not change — the stock return is set by economic realities, not by market forces. Market forces will diminish the differential but that cannot be done by lowering the stock return. Market forces will force the return paid on non-stock asset classes upward.
Investors get a win/win/win/win by a switch to Rational Investing:
1) The riskiness of stocks is greatly diminished;
2) The return on stocks remains as attractive as it was when risk was much greater (the Passive Era);
3) The primary cause of economic crises (the punch in the stomach we all feel when the artificial prices caused by promotion of the Passive “idea” crash) is addressed; and
4) Market forces force the returns on all non-stock asset classes upward.
Is there anything we we can do t speed up the transition to the Rational model?
Rob
Evidence Based Investing says
About those 6.5% real returns that you mention. I think you need to read this article by one of our favorite finance writers, Bill Bernstein.
The Returns Fairy… Explained
John Walter Russell says
I fail to see how the Gordon Equation changes anything that Rob has said.
P/E10 captures it all.
BTW, the Gordon Equation is NOT nearly as accurate as people imagine.
Have fun.
John Walter Russell
Rob says
I think it would be fair to say that that article was written by the Bill Bernstein who wrote Chapter Two of “Four Pillars,” Evidence. I of course agree with him that valuations need to be taken into account.
When you buy a share of the productivity of the U.S. economy, you are buying an asset that generates a 6.5 percent return. If you pay fair price for that asset, you get the 6.5 percent return. If you pay more than that. you obviously get less. There’s no law of the universe that requires you to buy stocks when they are overpriced. That’s a choice that some investors have elected to make in an effort to qualify as Passive Investors. Not recommended.
The Bernstein article is good stuff. I recommend that all community members read it. I recommend that Bernstein too read it and ponder its message and stop advocating Passive Investing. The only thing I see missing in the article is a clear injunction by Bernstein not to invest passively. My guess as to why those words do not appear is that Scott Burns nailed it when he observed that: “It is information most people don’t want to hear.”
I certainly applaud Bernstein for writing the article and I certainly agree with him that it addresses a topic of great importance. It is people like Bernstein who helped me to come to understand how stock investing works to the extent that I believe I have come to understand this today. I am of course grateful to him for teaching me. And I am grateful to you for linking to the article and thereby helping out our fellow community members.
Rob
Rob says
Drip Guy started a thread about me and my financial independence plan at the Bogleheads.org board. My take is that envy is the driver behind most of the comments made in the thread and that there are a large number of community members at the Bogleheads.org board who are entirely open to new saving and investing ideas but who are reluctant to speak up when Big Shots intimidate people into silence with the sorts of tactics that have often been employed by Drip Guy. Still, since the thread does relate to the saving ideas (and, in an indirect way, the investing ideas) explored at this site, I believe that the appropriate thing to do is to link to the thread and let community members form their own takes:
http://www.bogleheads.org/forum/viewtopic.php?t=44074&mrr=1255193060
Rob