Are Equities Riskier than Bonds?

Because individual companies are inherently riskier than entire nations, investors will apply a greater discount to future cash flows. This means that, if the business plan works out, investors will achieve a higher return on their invested capital. That’s why it is common to assume an equity risk premium when building a discount rate for companies. Valuators usually start with yields on government bonds and then add an additional risk premium for securities. A simple model suggested in the 2012 Ibbotson Valuation Yearbook is a 2.48 percent riskless discount rate (20-year U.S. Treasury Coupon Bond Yield) and a 6.62 percent equity premium (large company stock total returns minus long-term government bond income returns) with additional premiums that can be added for size, risk, industry, et cetera.

An article in February’s print copy of The Economist challenged this standard formulation. It is entitled Beware of the bias: Investors may have developed too rosy a view of equity returns. I’m open to the idea that investors are too rosy about equity returns, but I find almost every example cited spurious. I’ll quote liberally from the article and proceed point by point. Emphasis added throughout.

IF THERE is an article of faith among investors, it is that equities are the best investment over the long run, far better than government bonds. But research from Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School into returns since 1900, published this week in the “Credit Suisse Global Investment Returns Yearbook”, suggests that this belief is misleading. Their data show, for example, that global bonds have delivered a better return than equities since the start of 1980. Thirty-three years is a long time by most people’s reckoning.

Thirty-three years certainly is a “long time by most people’s reckoning,” but I imagine this doesn’t hold true over most thirty-three year periods. Here’s a graph of annualized changes in core CPI from 1957 through 2013 (read: inflation). Does 1980 through 2013 seem like a representative period?

Emphatically no! Coming into 1980, investors had good, historical reasons to expect high inflation over the life of their investment. This is not a large concern for most companies since it will increase the prices of both their inputs and outputs. Bond-holders, however, cannot tolerate unexpected inflation since returns are usually locked in at a high nominal rate. In 1980, investors funding the U.S. government through 20-year treasuries demanded a double-digit return since they expected inflation to overwhelm their position. When that inflation didn’t materialize, they experienced a windfall. I don’t know how true this experience was in the rest of the world, but it was certainly true in America, and Americans can proudly proclaim that our Economic screw-ups resonate across the entire world.

It is not surprising that bond holders experienced great returns over the past 33 years given the precipitous drop in inflation. It is surprising that inflation has been so low for so long, but that has nothing to do with the topic at hand.

At this point, the article temporarily drops comparisons between equities and bonds and compares equities of various countries on a global scale.

Add to that the problem of survivorship bias. Most investment research has focused on America, where there are a lot of finance professors. America was the great winner of the 20th century, both militarily and economically. Although its success seems obvious now, it was not the only great power a century ago nor was it the most-favoured market of early-20th-century investors.

The chart shows that in the 50 years after the end of the American civil war, the Russian stockmarket easily outperformed Wall Street. Russia, with its vast territory and industrialising workforce, was seen as the exciting growth opportunity for the 20th century. (Argentina was another favourite bullish bet.) The St Petersburg market was suspended at the start of the first world war but reopened briefly in 1917, just in time for a vigorous rally.

You can imagine the investment-bank research notes of the day. “The appointment of Kerensky is positive for shares. The tsar’s rule was erratic and a new technocratic government is in place. Now that the Russian market has reopened for business, St Petersburg is a buy.” Within a couple of years, however, investors in Russian equities and in government bonds and bills had all been wiped out.

This is an interesting point. Basing financial research on the U.S.’s experience, will show a strong return to equities. However, there was no prior guarantee America would have succeeded on the global stage, and many at-the-time-promising equity markets ended up not succeeding. In this case, studying the entire U.S. market ignores the survivorship problems of individual companies but unfairly introduces country-wide survivorship problems.

However, as I emphasized above, the problems that doom a country’s equity market also doom a country’s debt market. Catastrophic challenges to both do not prove that equities are overvalued relative to securities, they merely highlight the impact of geopolitical chaos.

It is certainly true that early 20th century Russia, Argentina and (as the article later expounds on) Austria suffered from extreme geopolitical chaos. These will distort any global, historical analysis of returns. It’s less clear that these disasters are important moving forward or are representative of the valuation of U.S. companies. I suppose I should be slightly concerned about the prospect of a Tsar being elected and destroying the New York Stock Exchange, but I think this is too speculative to have it affect the valuations of small companies.

Perhaps this does already weigh on the minds of investors, but you’d have to convince me this tiny rate isn’t already accounted for in the “risk-free rate.”