Risk and Expected Return


The last half of the twentieth century was a golden era for US equity investors. From 1950 through 1999 the S&P 500 Index produced annualized returns of 13.6% per annum, or a real rate of 9.2% per annum. Even more impressive are the returns of the last quarter of that century. From 1975 through 1999 the S&P 500 Index produced an annualized return of 17.2%, and a real rate of return of 11.8%. That is the good news. The bad news is that for today’s investors the result of those great returns is that today future expected returns are now much lower.

Unfortunately, most investors don’t understand the math of investing. They mistakenly simply extrapolate past returns into the future. This is illogical as is demonstrated by the following example. From 1926 through 1974 (the bottom of the worst bear market in post-war history) the S&P 500 returned 8.5% per annum. An investor simply extrapolating into the future would project future returns of 8.5% per annum. By 1999 the returns since 1926 had increased to 11.3% per annum. An investor simply extrapolating returns would now project returns of 11.3%. But prices paid for the same assets were much higher now. P/E ratios had risen to more than double their historic averages. And dividend yields, had fallen to a small fraction of their historical levels. How can one logically expect higher returns when paying much higher prices for the same assets? It is not logical. Today’s higher prices reflect a lower perception of risk and lower future returns, not higher future returns. Making this mistake of simply extrapolating past return can lead to very poor decisions about the need to save. Let’s explore the nature or risk and reward and how the price you pay impacts returns.

Every investor has a basic understanding of the nature of risk and reward. The relationship is positively correlated-in order to attract investors to take more risk they must be expect higher returns. The key word is expected. If the higher expected returns were guaranteed, there would be no risk. The risk is that the higher returns may not be achieved. For example, risky companies do default on debt and they do go bankrupt, wiping out equity holders. The greater the perceived risk, the higher the expected return must be. The higher expected return is reflected in a lower valuation of the asset. Conversely, the lower the perceived risk, the lower the expected return must be, as investors willingly pay more to achieve lower risk.

There is only one way to achieve spectacularly high returns like those achieved by US investors in the latter half of the last century-you must start out with the price of assets at very distressed levels, and end up with them at very elevated levels. This is exactly what happened. Let’s go to the videotape to see how the world looked in 1950.

As we entered the second half of the last century, what kind of investment climate did investors perceive? The US had just experienced two world wars and a great depression. The Korean conflict was brewing and communism was a great threat. Europe and Japan were in ruins. Not exactly a world safe for democracy, let alone equity investing. Those investors courageous enough to invest in equities would have been “rewarded” over the previous 21 years, from 1929 through 1949, with an annualized rate of return of just 3.8%, or a real rate of just 2.2% per annum. Not exactly rates of return that would excite today’s investors. Clearly the world was a very risky place, and prices reflected that risk.

The world turned out to be a far less risky a place than it was perceived at the time (remember we don’t have clear crystal balls). Capitalism and democracy won out. Russia collapsed. The SEC dramatically improved the regulatory environment, making investing safer. And, the economy grew with only one major interruption, the oil induced recession of 1973 and 1974. The change in perception of risk led to investors requiring a much lower risk premium to entice them to invest in equities. This reduction in the size of the risk premium demanded provided a very large one-time capital gain to investors. The offset is that the now lower perception of risk translates into much higher prices and, of course, much lower expected returns going forward. It cannot be any other way. The following analogy should help clarify this issue.

A bond investor purchases for $100 a bond of a risky company paying $12 in interest (yield is 12%). The next day the company is acquired by another company with a much better credit rating (lower risk). The rate on the new company’s bonds is just 6%. The market price of our investor’s bond will rise to $200, reflecting the lower risk of the acquiring company. This provides a one-time capital gain. However, the ongoing return is now 6%, not 12%. This is analogous to what happened to US stock prices. The world was perceived to be very risky. Prices were very low (expected returns were very high).

The world turned out to be less risky than perceived at the time and investors began to lower the premium they demanded to accept the risk of equity investing. Prices rose, providing the dramatic returns investors experienced. However, those spectacular returns are not repeatable, unless the perception of risk where to once again fall by similar amounts, something that is virtually impossible as we shall see. The high prices we now have reflect a low perception of risk, and thus low expected returns. Of course, the world could turn out to be far more risky than currently perceived. The result would be the reverse of the experience of the last 50 years-we would experience a collapse of prices and then expected returns would once again be higher.

Let’s turn to the math of investing. Estimating stock returns over the long term is really not that difficult (over the short term it is impossible, market timing is a loser’s game). The reason is that over the long term earnings ultimately determine stock prices, and corporate earnings tend to be a relatively stable percent of GNP (corporate earnings are unlikely to grow faster than GNP in the long term, or they would “crowd out” other components of the GNP like welfare, defense, government, wages, etc). If we assume that the GNP will grow at a rate of about 3% per annum (about the very long-term historical average) we can estimate equity returns by simply adding to that rate the dividend yield provided by stocks.

Today that rate is about 1.5%. Add 3% to that and we get an expected real rate of return to stocks of about 4.5%. If we add to that rate the expected rate of inflation (observable by subtracting the yield on TIPS from the bond yield) we get a nominal rate of return of about 6%. Note that the real estimated return of 4.5% is less than one-half the real rate earned from 1950 through 1999, and less than 40% of the real rate earned from 1975 through 1999. Investors simply extrapolating returns are highly likely to be disappointed. Investors depending upon those high rates in order to retire, are highly likely to find themselves working a lot longer or living a much lower than desired lifestyle.

Those forecasting higher returns must be assuming either a further drop in the risk premium (highly unlikely as we shall shortly see) or faster earnings growth. Can the economy grow faster than 3%, generating faster earnings growth? Sure, anything is possible. But the historical evidence suggests that 3% is a very good estimate. And, even if it were to grow much faster, say 4%, it would only add 1% to returns. And, it would not be prudent for investors making retirement plans to count on faster than historical growth occurring (they might end up broke).

There is another important caveat to our forecast of an expected real return of 4.5%. It is dependent on an important assumption. That assumption is that the risk premium demanded by investors remains unchanged. Given that we have currently have a virtually riskless instrument, called TIPS, yielding in excess of 3%, it seems highly unlikely that the equity risk premium, currently estimated at about 4.5%, could fall. After all, why would any rational person take the risk of equities without a compensating risk premium, which currently appears to be only about 1%?

It seems that with this low a premium, current equity prices reflect almost a perfect world, with little perception of risk (despite the events of September 11, 2001). On the other hand, it seems quite possible that investors could once again demand a higher risk premium (the world could turn out to be more risky). If this were to occur we would see a one-time drop in equity prices, and then once again higher expected returns, reflecting that now greater perception of risk. Returning to our bond example, it would be as if a highly rated company paying 6% on its bonds where to be acquired by a poorly rated company that had to pay 12% on its bonds. A $100 dollar bond paying $6 in interest would immediately drop in price to $50 (one-time capital loss), but the expected future return would now be 12%. Bear markets, restore equity premiums, bull markets deteriorate them.

We believe that it is extremely important for investors to have a working knowledge of financial history (or rely on an advisor that does). The reason is that “there is nothing new, only the history you don’t know.” Knowledge of financial history enables an investor to avoid the clarion call of “this time it’s different.” The low forecasted returns to equities are not unusual. Today’s valuations are very similar to those that prevailed in the in 1968 when the “nifty-fifty” and technology bubble broke. The very high prices implied very low future returns. And, that is exactly what occurred.

For the period 1968 through 1984 large growth stocks returned 5.8% per annum, 1.1% below the rate of inflation, and 3.1% below the rate of return on riskless, government insured, bank CDs. The risk premium was restored to equity markets, allowing for the spectacular returns of the last quarter of the century, when the S&P 500 Index fell 14.7% in 1973 and a further 26.5% in 1974. The now lower prices meant higher future expected returns. Those that do not know their history are doomed to repeat it.

It is important to understand that all of the above analysis is done at the broad market level. The small cap premium and the value premium are still alive and well. Those investors gaining exposure to those asset classes have higher expected returns than indicated above. In addition, those asset classes never experienced quite the bubble that did the large cap asset class, thus their risk premiums never eroded to quite the same levels. Thus we would expect that going forward the small and value premiums would be at least as large as they have been historically (unless of course the risk shows up, remember there are no guarantees).

To summarize:

  • Spectacular returns require that prices start at very distressed levels, a time when most people are afraid to invest in equities. Only bold and disciplined investors benefit.
  • Very high prices must reflect both a very low perception of risk and low expected returns.
  • There is a rational limit to how low equity premiums can fall (the benchmark riskless rate on TIPS). This does not mean, however, that prices cannot rise above that level temporary. In other words, greed and irrationality sometimes take over markets-it is called a bubble.
  • Current prices reflect very low expected future returns. Prudent investors build into their plans these low expected returns in order to have the greatest chance of achieving their financial goals (or they adjust their goals accordingly).
  • Investors should be prepared to adjust their investment/spending decisions on an ongoing basis as capital market returns impact their portfolios. A bull market leading to high returns can lower the need to take risk. Investors benefiting from that bull market should consider lowering their equity allocation accordingly (especially since expected future returns are now lower). Investors now expecting lower future returns may need to either increase their savings, or lower their financial goals accordingly. Ignoring market valuations is not prudent investing.
  • Bear markets restore risk premiums.
  • Young investors should root for a bear market so that future returns will be higher. Older investors should be very conservative in their equity allocations given the likelihood of low expected returns. If your need to take risk is low, taking it when risk premiums are low is certainly not prudent investing.
  • And finally, as Wes Wellington of Dimensional Fund Advisors states: “Just because I want to maximize my current spending but have a high degree of certainty that I won't exhaust my resources doesn’t mean the markets owe me such an outcome.”

Larry Swedroe is the author of "What Wall Street Doesn't Want You to Know" and "The Only Guide To A Winning Investment Strategy You Will Ever Need." He is also the Director of Research for and a Principal of Buckingham Asset Management, Inc. in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.