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Where A Risk Premium Exists

Where A Risk Premium Exists. Eric Falkenstein. Nature of Risk Exposed. From Super Safe to Safe Not from Safe to Insanely Risky Return Discount for Cash No alpha possible. AAA-BBB Spread. Moody’s data back to 1919 Return assuming 10 year bonds Can’t arbitrage: Can’t borrow at AAA rate

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Where A Risk Premium Exists

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  1. Where A Risk Premium Exists Eric Falkenstein

  2. Nature of Risk Exposed • From Super Safe to Safe • Not from Safe to Insanely Risky • Return Discount for Cash • No alpha possible

  3. AAA-BBB Spread • Moody’s data back to 1919 • Return assuming 10 year bonds • Can’t arbitrage: Can’t borrow at AAA rate • But, makes ‘sense’ in standard theory (if too much)

  4. If only this worked in more places…

  5. …like the rest of the Corporate curve

  6. Yield Curve – why buy 30yr bonds?

  7. What is the Equity Risk Premium? • The most important constant in finance

  8. Equity Premium Evolution • Mehra and Prescott (1986): 6.2% • 1999 Barclays and CSFB estimated 8.8% • Ibbotson (1926-97): 8.9% • Finance Texts (1998): 8.5% • Ivo Welch Survey (1998): 8.5% Crash! • AIMR estimate (2002): 3.0% • WSJ survey (2005): 2.0% • CFO Magazine (2005): 5% • Ivo Welch (2009): 2%-4% at most 1%-8%

  9. Some adjustments • Initial used T-bills instead of T-bonds • Arithmetic vs. Geometric averages

  10. People ignore costs all the time • Net cost of Vegas? • Beardstown Ladies investment club • 1983-94 return 23.4% • Best selling authors • Audited financials: 9.1%, below 14.9% for market • Failed to include contributions

  11. Geometric vs. Arithmetic Averages • 1 to 2 to 1 has a total return of 0% • 100%, -50% return has average of -25% • Arithmetic returns useful if you rebalance, as opposed to invest all your money at inception • Stock returns have volatility around 20%, for the indices, which implied a 2%

  12. Post WW2 Price-Earning/Div Yield Decline • US Dividend yield went from 7.43% in 1872-1950, to 2.55% from 1951 to 2000 • Fama-French (2002): about 4% of Post WW2 return from this effect • Ret=div+cap gain • If div rate goes down, one time cap gain

  13. Bad Market Timing • Dichev (2005) • 1, 2, 1 •  return 0% if cf is {-1,0,+1} •  return -17.7% if cf is {-1,-1,+1.5} • Total return different than Internal Rate of Return based on timing of investments • Distributions  Dividends-New Money • Corr(Distributionst,Returnt+1)= +33% • Corr(Distributionst+1,Returnt)= -27% •  bad timing

  14. Bad Market Timing • 1.3% premium for buy-and-hold and IRR for NYSE/AMEX 1926-2002 • 5.3% for Nasdaq 1973-2002 • 1.5% for 19 major international stock exchanges 1973-2004

  15. Transaction Costs • Commissions, • 8.5% load through 1970’s to buy a mutual fund • bid-ask cross • Stocks quoted at 8 ¾ - 9 in the 1990s • buy at 9, sell at 8 ¾, lose 2.78% • Phantom cost: most investors don’t know real time prices • Stoll and Whaley (1983) 1.78% comm+bid-ask • Bhardwaj and Brooks (1992): 4.4% total • Currently very low if you are smart (0.2%)

  16. Transaction Costs-Market Impact • No good data, proprietary • I have data from a dead Hedge Fund, so its not proprietary (ie, Deephaven) • Look at fill price, vs price at open • Generally, 0.2% using sophisticated algorithms on liquid stocks when putting on $100k • Around 1-5% when putting on 1-10% of Avg. Daily Volume

  17. Survivorship Bias • USA primary data point in World Value Weighted Index • Coincidentally, • 2-0 in World Wars • Communist Party not popular • Brown, Goetzmann, and Ross (1995) • Czechoslovakia, Hungary, Poland, Russia, and China all zeroed out • Jorion and Goetzmann (1999) • US real return 350 basis points above median for 39 countries in 20th century

  18. Peso Problem • Peso-Dollar FX rate fixed from 1954-76 • Higher interest rate in Peso • Peso ‘floated’ in 1976: lost 45% • Peso devalued by 82% in 1982 • Small probability, big loss, explains interest rate premium • Robert Barro (2006) argues a correct probability of a significant catastrophe explains much of the equity premium, about 300 basis points • 2% change of a 15% to 45% GDP decline

  19. Taxes • 10% stock return: 6% post tax with a 40% tax rate • Gannon and Blum (2006) apply this to S&P500 assuming 20% turnover from 1961-2005, using actual capital gains, dividend top-tier tax rates • Cap gain avg: 26% • Top tax rate avg; 49% (includes 6% state tax) • Total after tax equity return 6.72%, vs. 10.62% pre tax • Long Term Municipal Bond Buyer Index return: 6.14%

  20. Equity Premium Subtractions • Geometric vs. Arithmetic Averaging 2.0% • Survivorship Bias 3.0% • Peso Problems 3.0% • Post WW2 Reduct. in Eq. Premium 3.0% • Taxes 2.0% • Adverse Market Timing 2.0% • Transaction Costs 2.0% • Sum 17.0% • Most estimates around 3.5% for equity premium. With these additions, the Marginal Investor clearly could be seeing a 0% equity premium.

  21. Bottom Line • Risk premium exists in really low risk areas like • AAA-BBB spread • Short end of yield curve • Equity Risk Premium a mirage • Reasonable costs take it to zero for your average investor • Why is finance so remunerative? Selling dreams about getting rich, misdirection. • When alpha is possible, people are benchmarking, and selling hope

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