Sometimes it seems that the many estimates of the equity risk premium resemble the story of the blind men and the elephant. For those not familiar, the story involves the conflicting responses of six blind men who each are touching different parts of an elephant. The moral of the story is that they are not in conflict, rather they are each experiencing different aspects of the same thing.
The same could also be true of the equity market and our estimate of the equity risk premium.* A great deal of ink is spilled on the topic of the equity risk premium. Suffice it to say that the many estimates of the equity risk premium are tinged by recent history and its affect on researchers. Not surprisingly estimates of the equity risk premium are higher after periods of strong equity performance.
A recent post at Systematic Relative Strength shows just how different the equity market can look given recent history. They show the flip-flop in trailing 10-year total returns for the S&P 500 from June 30th, 2010 and June 30th, 2000: -0.8% vs. 17.8%. This reversal in fortune not surprisingly affects the way individuals think about the stock market. They do not however that:
Performance in a given asset class over the last 10 years doesn’t guarantee returns over the next 10 years. Given the tendency for markets to revert to the mean, it is quite possible that the returns of the S&P 500 over the next 10 years will be very good. Giving up on equities may prove to be a very poor decision over the next decade.
This idea of mean reversion is also found over at EconomPic Data. The chart below shows that historically the US stock market has bounced back after periods of low real returns.
Charts like this, and another version here, are of cold comfort to investors who have lived through a period of low, if not zero equity returns. All that seems salient is this recent history. Indeed Carl Richards of Behavior Gap may have summed things up best with the graphic below:
Source: Carl Richards
There is of course no guarantee that we will not experience another lost decade for stocks. Richards writing at the Bucks Blog notes the difficulties in trying to put any sort of estimate on the equity risk premium. He notes how our personal experience with the equity risk premium is largely a function of timing (and luck). Given our paucity of knowledge on the subject Richards concludes:
Ask yourself if you can you live through a prolonged period where you earn no risk premium at all, and make adjustments accordingly.
In short, plan for the worst (no equity premium) and hope for the best (mean reversion).
*For the moment we are going to leave aside the notion that there is in reality no equity risk premium.