Why do we demand a premium for the risk of stocks?
In short: Investors often demand higher returns for owning equities compared to safe assets like bonds. This 'equity premium' is rooted in a fundamental human desire: the need to smooth out consumption over a lifetime. If an asset doesn't protect us from poverty, we demand a discount on its price to compensate for the anxiety of uncertainty.
The core of the equity premium lies in the concept of consumption smoothing. Individuals accumulate assets to ensure a stable standard of living over their lives. Because the future is unpredictable, we seek a portfolio that offers various payoffs across different potential states of the world. If an asset fails to hedge against the risk of being 'poor'—meaning it provides high payoffs when we are already well-off but low payoffs when we are struggling—we require a discount. This discount manifests as a risk premium, where the current price of the asset stays below its expected return to satisfy our collective aversion to risk.
However, the stability of this premium is contested. While conventional wisdom suggests that equities provide a consistently high excess return because they are inherently risky, research suggests that equities do not provide a stable excess return over time. This lack of constancy may stem from deep structural changes in society, unexpected shocks, or specific policy responses. The relationship between risk and reward is not a fixed law but a moving target influenced by the evolving economic landscape.
Professor Jagjit Chadha uses the analogy of Aesop's fable to illustrate the difference between equities and bonds. Fast-moving stocks resemble hares, which often experience abrupt, enduring pauses. Steady bonds mirror tortoises, advancing consistently despite environmental conditions. In a 'long race'—the long-term investment horizon—the hare is likely to win provided the stops are not too frequent or long. But in a short race where a single long stop is probable, the tortoise may prevail. This distinction is vital for understanding why the 'equity premium' can feel so volatile in the post-crisis world.
The human element of this risk is perhaps best captured by Isaac Newton. After losing £20,000 in the South Sea Bubble of 1720—despite having previously sold shares at a 100 percent profit of £7000—Newton famously remarked that he could calculate the motions of heavenly bodies but not the madness of people. His experience serves as a reminder that while we try to model risk mathematically, the psychological weight of financial disaster remains a primary driver of how we price the world's assets.
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Sources
- Summary by Intellect · source: The Equity Premium and Low Interest Rates - Professor Jagjit Chadha
- Also: The Equity Premium and Low Interest Rates
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