Do equity returns justify the risk?

The answer to this question is one all investors need to consider but it should be determined by a comparison of returns from other investment types that carry low risk or “no risk.” By risk I refer to volatility of returns. Although investment risk is multi-faceted and means more than just volatility of returns, as highlighted in the next paragraph, for the purposes of this article volatility will be my focus.

I don’t consider any investment is risk free. The real value of cash is eroded by inflation whilst highly secure UK, German or US government bonds are subject to interest rate risk, if not credit risk. This means although the issuing government almost certainly will not default on its loans, bonds are driven by other market influences for example interest rate rises and consequently bond prices can fall. In some developed markets investors are paid a negative yield on holding government debt, meaning they are paying for the privilege of investing.

For an investor the question is can I get the same return elsewhere but with lower risk? If you can why invest in riskier assets? Consequently professional investors talk about risk premiums. It is commonly used in bond markets. Let’s say you can get a 2% p.a. interest rate on government debt. This is often referred to as the risk free rate. The question how much extra interest will investors demand for holding corporate debt, whether investment grade or sub-investment grade? In the US the latter are called junk bonds, a kind of reverse euphemism. Corporate debt carries credit risk (as well as interest rate risk) and the lower the credit rating of the issuing company of the bond the higher the interest rate they must pay to compensate investors for the extra risk. For investment grade bonds interest rates might need to be 3% p.a. and for sub-investment grade 4% p.a. You get the idea. The figures are for illustration only and don’t necessarily reflect current market rates.

Risk premiums are also applicable in the equity market too and here I want to share the thoughts of Glenn Meyer, head of managed funds at RC Brown Investment Management, a firm of discretionary fund managers that I have used for a few clients. In a recent newsletter he wrote:

“Mehra and Prescott found that between 1889 and 1978, the risk premium on US equities was 6%, but the largest premium they could derive from their model (by using standard measures of risk – which are focused on volatility) was 0.35%.”

Meyer also quoted a further study from Fama & French that found:

“…the long-term equity risk premium on the US equities was 6% between 1963 and 2016, but their data also encouragingly showed that as the time horizon increases bad outcomes generally become eless likely and extremely good outcomes become more likely…the high volatility of monthly stock returns and premiums means that for the three year and five-year periods used by many professional investors to evaluate asset allocations, the probabilities that premiums are negative on a purely chance basis are substantial, and they are non-trivial even for ten-year and 20-year periods.”

The clear conclusion is that long term equity investors are very well compensated or even over compensated for the extra volatility they experience compared to holding “risk free” government debt. This is certainly my experience in reviewing the profitability of long held equity investments and portfolios through thick and thin.

Glenn Meyer suggests that the risk premium for equities may fall as investors cotton on to the fact that the measured risk is much smaller than the equity risk premium but in the meantime he is happy to bank these incremental returns for his clients. I concur, and like Meyer as this point in the cycle I strongly favour equities for long term investment. However this is not to suggest that valuations are unimportant. Gary Potter co-head of the multi-manager team at BMO Global Asset Management suggests most assets are not cheap and expects returns over the next 10 years to be lower than the last 10. Investors should perhaps lower their expectations, be more discerning about what they buy and pay attention to true valuations. With the withdrawal of central bank monetary support, so called Quantitative Tightening (QT) active fund management is favoured in my view.

The content of this blog is intended for general commentary only and is based on my understanding of Glenn Meyer’s and Gary Potter’s views which they may not necessarily endorse. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.