R.I.P. ERP? Not Quite Yet

Why you shouldn't lose hope after the lost decade.

May 27, 2010

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951616_77350444The S&P 500 had a dismal return over the past decade. The lucky few with a long-term horizon got out with a minimal haircut. Newbies — those who started 10 to 12 years ago — not so well. They lost money. So what happened to the equity risk premium? If the premium was rewarded, it certainly wasn’t because the house of equities failed to burn down. In fact, it did burn down — the risk in owning equities was realized —  but like AIG, the insurance didn’t deliver.

Once in a lifetime? Not exactly. Twice in ten years? Yes. That’s caused CalPERS, among other pension funds, to recalibrate, if not expectations, then the risk profile. CalPERS conducted a seminar earlier this month, to visit return expectations. In the prelude, CalPERS trustees were exposed to more than a few fundamental questions. Among them, the relationship between the policy portfolio and actual capital market behaviour. Or to quote from one of the slides:

• Modern portfolio theory assumes a return premium for risky assets.

• The equity risk premium (ERP) is a key driver of asset allocation decisions. ERP = Equity Return – Bond Return

• A positive ERP is evident over long periods of time. However, there are intermittent periods when it did not materialize as in the recent decade.

That said, some are concerned that gazing at the past may risk missing an opportunity. Tadas Viskanta, the editor of the blog Abnormal Returns, turns in a useful summary of current debates on the equity risk premium. His conclusion: “However even in a “lost decade for stocks” scenario there are going to be opportunities along the way.  As we have discussed previously stock picking skills will be of great value in a period of increased volatility.  Opportunities might come in other parts of the corporate credit structure or in markets not even recognized as such today. ”

To paraphrase a certain actor: “we earn the equity premium the hard way — we work for it.”

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