Fine Print - November 2010

Taking the reward out of risk
By G.D. Gearino

Lately, I’ve been reading much about the “equity premium” — that extra bump in return you enjoy from investing in the stock market, where there is risk, rather than investing in government bonds and such, where there’s almost none. That premium, of course, is the reward in the risk-and-reward formula that serves as one of the foundational blocks of capitalism. The greater the risk, the bigger the payday if the cards fall your way. Everybody understands this. God knows, a whole retail investment industry has been built on the notion that stocks ultimately outperform almost all other investments.

But what if there’s no equity premium nowadays, or at least not much of one? One study I reviewed showed that the extra value stocks bring to your portfolio has faded decade by decade. Somebody else flatly declared that the equity premium didn’t exist anymore — and hasn’t for three decades. (More about both claims in a moment.) That last assertion was especially troubling, because the past 30 years pretty much represent the span of my investing career, which — small-bore as it may be — was launched in the belief that stocks would leave me better off in the long run. Now I find out that among the pointy-head crowd of academics, theorists and math wizards, there’s a long-running debate over whether investors actually get much reward for their risk. It’s a disturbing thing to have one of life’s fundamental certainties questioned. What else am I going to find out? That I didn’t actually win that Pulitzer Prize I assumed had been lost in the mail all these years?

Back to the two findings mentioned above: The first is a 2000 study published in the Federal Reserve Bank of Minneapolis Quarterly Review (yeah, there’s some light reading), which shows that the equity premium declined every decade between 1950 and 1990 before making a modest rebound in the 1990s. Not that the rebound helped much, though. According to the study’s conclusion, “The premium averaged about 7 percentage points during 1926-70 and only about 0.7 of a percentage point after that.” The subsequent decade, of course, has proven to be a flat-liner for stocks, a point driven home by the second report I found — a 2009 analysis from Bloomberg News that showed that, for the first time since 1979, a 30-year Treasury bond had a better return than did the widely watched MCSI World stock index. Or as one fund manager told Bloomberg, “Over the last 30 years there’s been no risk premium.”

It’s in moments like this when you turn to experts for comfort and solace. I reached out to a trio of wise persons, only to end up not with soothing reassurance but something closer to a cold dose of reality. For instance, Michael Brandt, a finance professor at Duke University who’s working with QMS Capital Management in Durham during a one-year sabbatical, believes the equity premium is rising again. Still, he says, “institutional investors are concerned about, and rethinking, expected return targets.” Furthermore, the average retail investor (meaning me, and everyone else with their retirement money planted in mutual stock funds) needs to “re-evaluate their obsession with equities.” When you put those two thoughts together, they seem to indicate the easy fruit has been picked. Or, to switch metaphors, if investing were football, we’re looking at grinding out short yardage.

Brandt also pointed out that pension fund managers are particularly stressed these days, because where the rest of the world can simply scale back expectations of prosperity, pension funds are saddled with hard targets of return. That made me think Janet Cowell, North Carolina treasurer and the person in charge of the state’s $65 billion pension-fund portfolio, would have thoughts on the matter. She does, surely, but she’s not sharing them with me — at least not in time to include them in this article. After more than a week of trying unsuccessfully to schedule a time to talk, the best I got was a short statement from her chief investment officer. He noted that while the equity premium is “dynamic” and “volatile,” he and the treasurer “continue to believe that investors will earn a premium on their equity holdings over the long-term.”

Sound familiar? It’s the same bland utterance every average-Joe investor hears from brokers and financial advisers. I felt like I had been patted on the head and told everything is going to be just fine. But as someone else later pointed out, I couldn’t reasonably expect the state treasurer (who is a politician, after all, albeit one with an impressive résumé) to say, in essence, “Yeah, we’re toast.”

That “someone else” is a North Carolina money manager who agreed to talk to me if I agreed not to share his name. He’s a smart fellow, prone to candor with friends and clients (but not so much with the rest of the world, hence the anonymity). He makes two points: First, that investment professionals have long tried to have it both ways, by selling the idea of a risk premium and simultaneously selling the idea that there’s really no risk if you have a long-term horizon. Second, that nothing pays a premium to attract capital if everyone’s investing in it anyway — and that’s what has hap- pened with stocks. Fifty years ago, almost no one was in the market. Today, we’re all equity investors. The only way we’ll ever get a reward again for taking a risk is if a whole bunch of us stop taking the risk.