Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 587

Is this bedrock of financial theory a mirage?

One of the foundational beliefs that drives strategic asset allocation is the existence of the equity risk premium (ERP)  – that is, that by taking on greater risk of owning equity an investor will be rewarded with greater return.

Based on research undertaken by Jeremy Siegel[1] in the early 1990s “The Equity Premium: Stock and Bond Returns since 1802”, (and expanded by others in following years), very long run data on stock and bond returns was compiled which purported to show that stocks outperform bonds over the long run.

Combined with other research like the annual Credit Suisse Global Investment Returns publication, which many have utilised over the years, the existence of an ERP of 3-4% per annum (an 8% equity return versus a 4% bond return) has become embedded in investment return assumptions.

These assumptions drive the high allocation to equities typically present in diversified investment portfolios. Yet recent updated research suggests that the existence of the equity risk premium may be more episodic than these assumptions imply. 

A paper published almost a year ago in the Financial Analysts Journal[2], “Stocks for the Long Run? Sometimes Yes, Sometimes No”, by Edward F. McQuarrie, questions this fundamental assumption.  The paper extended the historical analysis back further to 1792 and, importantly, updated it to:

  • Include securities trading outside New York (in Boston, Philadelphia, Baltimore and southern and western US cities), increasing the coverage to 3-5 times more stocks and 5-10 times more bonds;
  • To capture more failures, reducing survivorship bias;
  • Include federal, municipal and corporate bonds; and
  • Calculate a cap-weighted total return for stocks.

While historical data must be treated with a significant caution, especially over such long periods, these enhancements appear to be a large improvement on the original data. For more detail see the paper, which details the methods and contains links to the files containing raw data, for use by future researchers.

Shortcomings remain, such as annual frequency of data, time-averaged data and exclusion of stocks that traded over the counter. Yet the impact of these enhancements are significant. Stock returns before 1871 are much weaker due to the reduction in survivorship bias, while bond returns look more positive due to the broader collection of securities. 

The chart below from the paper shows the new record since 1792, and is quite striking. Two recent periods are highlighted (stock outperformance post World War 2 to 1980, and the period since 1980 to now), with the bond performance line also reset at the beginning of 1980 to facilitate comparison.

Stock and Bond Performance Since 1792
(including bonds rebased to 1981)

The revised record suggests that the strong period of equities outperforming bonds was mostly in the post-WW2 period up until 1980.  Since 1980, stocks and bonds have performed about the same: while stocks have had periods of outperformance (tech boom up to 2000, pre-GFC, and the current AI rally), they have been followed by reversals.  Meanwhile the decline in inflation and bond yields meant that bonds have kept up with equities since 1980.

Over the very long run, the data suggests that the ERP did not exist in the 150 years before World War 2 (WW2) and the 40 years since 1981.  It was only the period from post WW2 to 1980 that the ERP was clearly evident.  The implication is that rather than being a long-run phenomena, the ERP may have been a 'short-term' event triggered post WW2 until the early 1980s, which has then been baked into historical returns that have been used to 'prove' its existence ever since.

Clearly the existence, or not, of an ERP has significant implications for portfolio construction. To just note two: if the ERP is in fact much lower than normally assumed, there is less need for portfolios to load up on equities to generate returns. It also impacts the total expected return for a portfolio, which has implications for retirement planning.

Unsurprisingly, the paper has generated a lively debate among leading US finance academics.  For those interested in further discussion of this topic, the CFA Institute Research Foundation will shortly publish some of this commentary, which will undoubtedly be insightful and interesting!

 

Phil Graham is an independent director and consultant, and a former Chief Investment Officer. He currently serves as a Trustee on the CFA Institute’s Research Foundation.

 

[1]  Siegel, J.J. (1992); “The Equity Premium: Stock and Bond Returns since 1802”, Financial Analysts Journal, Volume 48, Issue 1,  (1).
[2]  McQuarrie, Edward F. (2023); “Stocks for the Long Run? Sometimes Yes, Sometimes No”, Financial Analysts Journal, Volume 80, Issue 1. 

 

  •   20 November 2024
  • 3
  •      
  •   
3 Comments
Jim
November 22, 2024

It's at a fascianting junction with the ERP for US stocks now at 23 year lows. Let's see what it means for future returns.

Steve v
November 28, 2024

That is a pretty amazing length of data that does call into doubt the consistency of stocks outperformance compared to bonds.

The other data that seems to me to be relevant is the data for every other country apart from the US. The US has done well economically the last 100 years compared to a lot of other countries. But what about a country like Argentina that was prosperous and then became much less so with hyper inflation etc. Presumably real bond returns there were deeply negative and maybe something like a total wipeout. What about countries that had communist revolutions where private property was confiscated. Presumably the returns on stocks and bonds was 100% loss for both over various periods.

I guess the main thing is to say the possible returns vary very widely and it depends on economic and political factors. A good argument for having a diversified portfolio and understanding that any investment can be a bad one.

Warren Bird
November 28, 2024

Interesting historical analysis - I love charts going back centuries.
But I don't know any asset allocator worth their salt that believes in a static, always reliable, equity risk premium. So, this "new research" doesn't actually tell me or my colleagues in the industry anything new at all. We've always known that the relativities for expected returns across asset classes are very dependent upon the starting point, both in terms of the levels for asset prices and valuation metrics, and the pathway of the fundamental drivers of changes along the way.

I for one wrote a paper in about 2003 in which I said something like, "so the long run over which equities 'always outperform' is clearly longer than 9 years." The context was that I'd done some analysis on how investors who went into the Australian bond market in January 1994 - the month before the biggest sell-off ever kicked off - fared subsequently. It was 9 years later and, lo and behold, bond returns had beaten stock market returns over that period. This is despite the first 9 months or so of that period being the biggest negative returns for bonds we'd seen.

Equities are more risky investments and SHOULD be priced to deliver a risk premium. A lot of the time they are appropriately priced, but sometimes they are overpriced and most likely won't deliver superior returns over the medium to long term. The skill is identifying both when that is the case and when the market is going to realise it and correct asset prices accordingly. Not in assuming that they'll always do better because of a mythical constant equity risk premium.

 

Leave a Comment:

banner

Most viewed in recent weeks

Australia's retirement system works brilliantly for some - but not all

The superannuation system has succeeded brilliantly at what it was designed to do: accumulate wealth during working lives. The next challenge is meeting members’ diverse needs in retirement. 

Australian stocks will crush housing over the next decade, 2025 edition

Two years ago, I wrote an article suggesting that the odds favoured ASX shares easily outperforming residential property over the next decade. Here’s an update on where things stand today.

The 3 biggest residential property myths

I am a professional real estate investor who hears a lot of opinions rather than facts from so-called experts on the topic of property. Here are the largest myths when it comes to Australia’s biggest asset class.

Get set for a bumpy 2026

At this time last year, I forecast that 2025 would likely be a positive year given strong economic prospects and disinflation. The outlook for this year is less clear cut and here is what investors should do.

AFIC on the speculative ASX boom, opportunities, and LIC discounts

In an interview with Firstlinks, CEO Mark Freeman discusses how speculative ASX stocks have crushed blue chips this year, companies he likes now, and why he’s confident AFIC’s NTA discount will close.

Property versus shares - a practical guide for investors

I’ve been comparing property and shares for decades and while both have their place, the differences are stark. When tax, costs, and liquidity are weighed, property looks less compelling than its reputation suggests.

Latest Updates

Superannuation

Meg on SMSFs: First glimpse of revised Division 296 tax

Treasury has released draft legislation for a new version of the controversial $3 million super tax. It's a significant improvement on the original proposal but there are some stings in the tail.

Investment strategies

10 fearless forecasts for 2026

The predictions include dividends will outstrip growth as a source of Australian equity returns, US market performance will be underwhelming, while US government bonds will beat gold.

Infrastructure

How many hospitals will an extra 1 million people need?

We're about to add another million people to cities like Brisbane, Sydney, and Melbourne. How many hospitals and other essential infrastructure are needed to cater to a million more people? This breaks down the numbers.

Risk management

Is the world's safest currency actually the riskiest?

The US dollar’s long-standing role as a ‘shock absorber’ during times of market stress is showing cracks. The ‘Liberation Day’ sell-off was a timely reminder of this, and here's what investors should do about it.

10 things I learned about dementia and care homes from close range

My mother developed dementia before eventually dying in June last year. She was in three aged care homes before finding the right one. Here is what I learned along the way.

Economics

China's EV and solar backlog and future trade wars

China has flooded the world with electric cars and solar panels to offset the economic drag from a weak domestic property market. How long can this go on, and what are the implications for commodities and Australia?

Investment strategies

Why Elon Musk's pay packet is justified

Tesla copped criticism after its shareholders approved a package allowing Musk to earn up to $1 trillion in stock options. If only Australian businesses were more like Tesla.

Sponsors

Alliances

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.