Tuesday, 1 April 2008

Book Review: The Equity Risk Premium by Bradford Cornell

The equity risk premium is the difference between the rate of return on common stock and the return on government bonds or T-bills. For the individual investor, the amount of the premium is a critical input to investment planning for savings and for retirement. When those ubiquitous savings calculators ask for your estimate of future growth of your investments, it is important to use a realistic estimate, otherwise you may be sorely disappointed years down the road.

The objective of this book is to examine the equity risk premium in detail and come up with an answer, as the sub-title - The Long Run Future of the Stock market - suggests. Little did I know beforehand that it could be looked at from so many angles. Cornell summarizes and integrates the findings of the many financial economists who have carried out all the slicing and dicing of the data up to the 1999 date of publication. As such it is an invaluable monograph of the subject and the six pages of references provide any finance aficionado or student the core reading list to see the original material. The book itself presents little or no math, confining itself to basic formulas like the dividend discount model and the Sharpe ratio as the support for the often subtle economic logic.

The author writes clearly, carefully and directly with no embellishment and no deviation from the central topic. The style may be a bit dry but that is not a deficiency in my mind, since clarity and precision are paramount. Entertainment and pizazz are not the aim. The book did not provoke boredom, though one must keep in mind that I also read books on tax out of interest. The intended audience is intermediate to expert level.

The book seems quite linear in the progression of its argument, which is a testament to good organization of the material. There are only 217 pages in the book, including 22 pages of a table of monthly return data for US stocks, government bonds, T-bills and inflation from 1926 to 1997 (why bother with that anyhow?)

What does Cornell conclude from his review of all the evidence and studies?
"The future will not be as bright as the past. ... from 1926 to 1997, the average equity risk premium was 7.4% over treasury bonds and 9.2% over treasury bills. Investors cannot reasonably expect equities to produce such large premiums going forward. Instead, premiums are much more likely to be on the order of 300 to 400 basis points [i.e. 3 to 4%] lower."

But, he says, "... even with a lower risk premium, stocks still remain an excellent long-run investment in comparison to bonds." That's because stocks at a lower premium can reasonably do better by around 5% per year. A key reason is that stocks do better in the face of inflation.

The absolute real (after deducting inflation) expected rates of return, with the downward adjustment to equities as Cornell suggests, would work out to (using his data in table 1.3):
  • T-bills 0.5% per year
  • Long-term/ 20 year Treasury bonds - 2.5% per year
  • Equities (S&P 500) - 5 to 7.5% per year
Cornell gives advice to pension plans and individuals saving for retirement: "... fixed benefit funds face two choices: they can increase (1) funding for the plan, or (2) the fraction of the fund invested in common stocks. ... Employees on fixed-contribution plans or who are funding their own retirement plans face the same tradeoff. To achieve an expected dollar standard of living in the face of declining expected returns on equity, they must either save more or increase the fraction of their portfolio allocated to common stocks."

Apart from these core conclusions (which we ignore at our own peril), there is much else to savour in this book, which a few quotes will serve to suggest:
  • "Fama and French reported that stock returns tend to be mean reverting, so that periods of abnormally high returns tend to be followed by periods of below-aerage returns." (page 55)
  • "... in the years following 1926, when detailed stock market data became available, the United States led pretty much a charmed life. ... As of 1926, it was not clear that the future was going to be so bright." (60) ... compared to countries like Germany, France, Italy, Russia and Japan; I think of this as using Tiger Woods to portray the average golfer. Would someone please tell me whether the US will continue to be so wonderful for the equity investor?
  • "... the collapse of the gold standard led to a worldwide bias toward higher rates of inflation." (75)
  • "Given the widespread distribution and acceptance of the Ibbotson data, it is not unreasonable to assume that today's investors have significantly different beliefs than their depression-age predecessors regarding the long-run risk-return tradeoff offered by common stocks and competing fixed-income assets." (174) i.e. today's investors have a pretty rosy picture of stocks.
  • "A bubble, however, is inherently unstable. Because it is not based on fundamental valuation, all that keeps a bubble going is the expectation of higher prices next period." (185)
  • quoting then Federal Reserve chairman Alan Greenspan in 1998, "The abrupt onset of such [stock market] implosions suggests the possibility that there is a marked dividing line for confidence. When [it is] crossed, prices slip into free fall - perhaps overshooting the long term equilibrium - before markets will stabilize." (190) ... i.e. there is money to be made in market panics
One paper cited by Cornell is the paper A Century of Global Stock Markets by William Goetzmann and Philippe Jorion at the Social Science Research Network. Within that paper is the comforting information that one does not have to pick the next "USA-like superstar stock market country"... we find that the performance of a globally diversified portfolio is much closer to the performance of U.S. equities, averaging 4.0%" (they found the U.S. performance was 4.3%). Canada's real return was far behind at 3.19% and the UK's was even worse at 2.35%. Global diversification, anyone? P.S. no, I cannot explain the difference between the return numbers in this paragraph and those of Cornell cited above - no doubt there are differences in methodology like inflation calculation, time periods, adjustments of the data to compare amongst countries.

About the only criticism I have of this fine volume is its high price, $100 CAD on the dust jacket, though it sells for $47.51 on Chapters. There is also a typo in formula 3.2 on page 103 - the book shows the constant growth form of the dvidend discount model as k= Div1/(P+g) whereas it should be k=(Div1/P)+g. The text below is correct, however. My rating 4.9 out of 5.

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