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The Puzzling Equity Premium Quietly Leading You to Pitfall

While stock returns have for decades outperformed risk-free rates in the U.S., the idea that this premium is an immutable, inherent feature of the asset class strikes Institutional Investor columnist Christopher Schelling as naive.

  • Christopher Schelling

The equity risk premium is one of the great puzzles of modern finance. And yet it’s perilously taken for granted.

The premium is the excess return stocks produce compared to a risk-free rate of return reaped from investments in safe securities such as U.S. government bonds. While it’s easy to measure historically — averaging around 4 percent to 6 percent annually over the past 60 to 80 years — the reason for the supposedly reliable results is less obvious.

Most economists argue this excess return comes as compensation for having accepted higher risk, and they’ve developed models to forecast the premium investors will get as their reward for buying stocks. But these models don’t explain why the premium has been so wide and why it has persisted for so long.

If it’s so substantial and reliable, is it actually higher risk? Perhaps the question is: Why haven’t stock prices risen even higher since the excess return compared to Treasuries appears to be a foregone conclusion?

But before delving too deeply into that, let’s turn to another complicated concept to fit some more pieces into this puzzle: the human search for meaning. One of the fundamental observations of modern psychology is that people have a powerful drive to make sense of the world around them, resulting in spontaneous attempts to explain observed, or perceived, patterns.

While conducting research at the University of Illinois at Urbana-Champaign in 2014, psychologists Andrei Cimpian and Erika Salomon introduced the concept of the “inherence heuristic” in a paper published in the journal Behavioral and Brain Sciences. Building on earlier work by Nobel Prize winner Daniel Kahneman on two types of thinking — fast and intuitive versus slow and deliberate — the authors explored the fast, intuitive cognitive process of identifying causal relationships.

Under the concept of the inherence heuristic, people process easily accessible information relating to a pattern they’ve identified and intuitively arrange it into a compelling narrative to explain causality. It’s a mental shotgun approach to reasoning, as opposed to the more systematic and rigorous thinking that goes into deliberate cognitive processes.

Quick mental processes prefer the path of least resistance, with the easiest answer derived from superficial characteristics that are labeled inherent features.

Here’s how it looks in practice: A primitive man drops rocks and logs into a river. The rocks always sink and the logs always float. He concludes rocks are inherently heavier simply because, well, they’re rocks.

Despite the shallow reasoning, the patterns are deemed stable and inevitable precisely because the identified characteristics are believed to be immutable and inherent.

In other examples of labeling, people tend to view blue as masculine and pink as feminine. If you feel such relationships are natural and inevitable, that’s the inherence heuristic ascribing gender as intrinsic to the colors.

The scientific method — a very deliberate process of thinking — has given modern humans a deeper understanding of causality. We’ve discovered that rocks and logs are composed of similar elements such as carbon, oxygen, iron, and potassium. And that the density of atoms in solid objects, or the amount of matter per unit of volume, determines what floats or sinks, not any inherent feature of rock.

Now back to the equity risk premium.

While stock returns have for decades outperformed risk-free rates in the U.S., the idea that this premium is an immutable, inherent feature of the asset class strikes me as naive.

We should know by now that stock market returns come from underlying factors such as dividend yield, corporate earnings growth, and the expansion of price-earnings multiples. By digging into its various features, consider how the Standard & Poor’s 500 index has performed in the past 50 years.

In 1966 the five-year annualized earnings growth rate for companies in the S&P 500 was 10 percent and the trailing 12-month price-earnings ratio was 14.8. At the end of 2016, the five-year annualized earnings growth rate was 2.3 percent and the market was paying 20.6 times earnings to own the S&P 500.

Perhaps more importantly, the dynamics behind these measures have changed significantly.

Earnings growth in past decades was fueled by massive improvement in productivity stemming from industrial and digital innovations, strong demographic tailwinds, and growing use of leverage financed at progressively lower interest rates. Today we have a massive debt overhang with interest rates near all-time lows, stagnating productivity, and an increasingly aging population.

Meanwhile, the eight-year bull market persists, with the S&P 500 returning 16 percent in the 12 months through May 19.

Public equities may well outperform Treasuries, and I suspect they will. But I’m not sure there is any inherent reason to expect the premium to look anything like it used to just because, well, they’re equities.