It is hard to overstate the importance of the equity risk premium or ERP. In Abnormal Returns: Winning Strategies From the Frontlines of the Investment Blogosphere I devote an entire section to the topic. I start the section with a quote from Aswath Damodran from his paper at SSRN:
Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice.
To some degree the ongoing debate about the precise level of the equity risk premium is a bit of a red herring. Although I discuss at more length does it really matter whether the ERP is 2% or 4%. In either case you the investor has no control over what the equity markets are going do over the short and long term. All you can do is control your own behaviors.
The ERP as discussed in the academic literature is to a large degree a theoretical construct. What is being measured, and estimated, is the ERP on some basket of stocks that may or may not have been particularly investable at the time. With the widespread adoption of indexing at increasingly low costs we are today at least approaching some convergence between the theoretical ERP and the actual ERP.
I wish I had emphasized this point more in the book, especially in light of a series of posts that have recently appeared. Eric Falkenstein who I quote in the book has a post up entitled “Who Gets the Equity Risk Premium?” that gets at the issue of how a theoretical ERP is not what the average investor actually ends up earning. If this post would have been out when I wrote the book I would have quoted from it, but here is an extended look at the post’s conclusion:
In many ways, investors are like all those people who recall their last trip to Las Vegas left them flat or up a little. The equity risk premium can be thought of as a very subtle equilibrium, where the efficient investor who makes a 3% premium is the loss-leader to equity issuers, and the average investor more than makes up for this ‘expense’ to the insiders. Though an efficient investor may be able to invest in efficient passive funds and capture much of the equity premium, such an investor is the exception in the same way that your average blackjack player loses considerably more per hand than your robot optimizer. That is, just as most hedge fund profits go to hedge fund owners, most outside equity investment goes to insiders—brokers, management, initial equity owners—via the persistent mistakes and carelessness of your average investor. Equity returns are not simply a stochastic process that a singular representative investor chooses, but rather a complex set of returns depending on the strategy and tactics used by heterogeneous investors, many of whom make conspicuously inefficient choices. The bookies, and the insiders selling dreams, always win, and if they didn’t the market would not exist as it currently does. The equity risk premium is zero for the marginal investor.
Maybe a more important question is why is it that investors seem to accept their lot with such equanimity. In a review of the same ground Tim Richards in a post entitled “Your Self-Inflicted 6% Tax” discusses the many ways in which investors shoot themselves in the foot and are likely to continue doing so. From the post:
A couple of behavioral reasons are adduced for the fact that this abysmal situation has been allowed to continue for so long. Firstly, the excessive returns generated in the 1990’s has caused both professionals and traders, who learned their skills in that period, to anchor on the “fact” that you can get extremely good returns simply by investing in stocks. We’re stuck in a mode of belief about an idea that died around the turn of the century. Everyone’s hanging around awaiting the imminent return of the good times, but it’s not going to happen.Secondly, the fact that returns are so poor has probably been hidden by inflation. This is simple money illusion at work: if your returns are 20% you’re still losing ground if inflation is at 21%, but you’re probably happy about the fact (see: Money Illusion). We focus on nominal returns, not real ones.
In case you needed any more reasons to approach equity investing with a bit of caution let James Altucher provides you with”10 Reasons You Should Never Own Stocks Again.” Altucher emphasizes that the competition in the equity is brutal and that for most people trying to beat the market is a big waste of time. As I also note in the book there is a speed limit on just how high of returns even the best investors can earn. Altucher writes:
7.The best investors in the world make on average between 10 and 15%. We already know because of the above that you are probably not going to be among the best. So, if you pick some stocks and passively hold them maybe you’ll earn half that: 7%. Are you happy with that? Then fine. But given the volatility in the market I don’t think thats a good enough return for most people. Look,some people are good. And some people should invest. But most shouldn’t.