This week, Gail explains why stock returns are expected to be lower in the years ahead.

Dear Friends,

Forgive me if I get a bit technical this week; I need to do so in order to explain an important concept that affects anyone who invests in stocks. It’s called the “equity risk premium.”

As most investors understand, a stock is inherently risky. Not because its price fluctuates, the value of all investments — bonds, gold, real estate, etc. — fluctuates. In fact, in some years bond prices have been more volatile than equities.

The reason stocks are riskier than bonds is that they have a lower priority in the event a company fails. In a bankruptcy, creditors get first dibs on any assets. This includes suppliers, banks, the phone company, and investors who loaned the company money by purchasing its bonds. Next on the list are investors who own “preferred” stock (now you know where the name comes from).

“Common” stockholders divvy up the remaining assets, assuming any are left. In exchange for accepting this risk, common stockholders expect to be compensated in the form of higher expected returns. Thus the term “risk premium.”

The “premium” is the additional return you expect compared to taking no risk at all. Where can you find a “risk-free” investment? The United States Treasury. It’s never defaulted on its debt. Ever.

Three-month treasury bills are commonly considered a riskless investment. Why? Because they’re issued by the U.S. Treasury Department and you get your money back in 90 days. The downside, of course, is that because they are such a safe investment, they don’t have to pay much. Right now, 3-month T-bills have a yield of 2.8 percent.

Trouble is, 2.8 percent probably isn’t going to help you accumulate the kind of money you’re going to need in order to retire.

Other treasury debt is also considered “risk free,” provided you hold it until it matures. Take 20-year government bonds. Although the Treasury isn’t issuing new long-term bonds, there are plenty still on the market.

Provided you hold a treasury bond until it matures, you will receive interest payments twice a year and you will eventually get back the face value of the bond itself. (Note to bond aficionados: Please don’t e-mail me about “premium” and “discount” prices! Going into that would confuse the issue.)

Of course, if you are a long-term investor, you face an additional risk: inflation. As Joseph McAlinden, chief investment officer of Morgan Stanley, likes to say, “Inflation is theft.” When the cost of living goes up, your dollar buys less. Inflation steals purchasing power.

One of the reasons long-term bonds pay more than short-term debt is to compensate the bond investor for the impact of inflation.

Long-term equity investors also expect a little extra in their return to make up for inflation. One way to estimate the expected return on stocks is:

Inflation Rate + Risk-free Rate + Equity Risk Premium

Ibbotson and Associates, a major provider of financial market data and consulting, estimates that over the 20th century (1926 through 1999, to be exact), the equity risk premium — the extra return stock investors expected — averaged about 5.25 percent.

Over this same period, long-term government bonds, which incorporate both the risk-free rate of return and an inflation factor, produced an average annual total return of 5.1 percent last century. When you add the equity risk premium to this, you come up with should expect stocks to return:

5.1 + 5.25 percent = 10.35 percent.

Voila! Darn close to the actual annualized return on equities over the 20th century.

OK. Here’s the point of all this: Ibbotson and others do not think the equity risk premium is going to be as high this century as it was in the 20th century. Translation: don’t expect the kind of equity returns we saw (especially in the latter part of the last century) to continue.

Peng Chen, Ph.D., one of the authors of the Ibbotson study, said a major reason for the double-digit returns the stock market produced last century was “a big P/E increase.”

The Price/Earnings ratio tells an investor what you have to pay for each dollar in earnings the company reports. If a stock is selling for $30/share and the company earns $2/share, the stock is said to have a P/E of “15.”

According to Chen, the average price/earnings ratio back in 1926 was 10. By the end of century, the P/E ratio had doubled, as investor optimism about the potential future earnings of companies soared. (Think “tech stocks” in the late 1990s. Some of them had ridiculously high P/Es!)

According to Chen, the average P/E was roughly “25” at the end of 2001. It has since come down to around “20.”

The research Chen co-authored with Robert Ibbotson pegs the equity risk premium at just under 4 percent for this century — down from the 5.25 percent we saw last century. Why? Well, as they like to say on Wall Street, “Trees don’t grow to the sky.” Or, in Chen’s words, “P/Es cannot increase forever. That’s not reasonable.” So Ibbotson and Chen took this out of the equity risk premium amount.

This means that going forward, we should expect smaller returns from stocks. Single-digit returns. Let’s plug some values into the above equation. (To mirror the approach Ibbotson used, we’ll use the current yield on 20-year treasury bonds as the risk-free return + inflation). Thus, the expected long-term annual return on stocks is:

20-year Treasury yield + Equity Risk Premium

4.68% + 4%

8.68%

Chen emphasizes that this is the average annual return over, say, 20 years. In some years the return will be higher; in others it will be less. In addition, this is the expected return on the broadly diversified S&P 500 Index. Smaller companies have greater risk, so their stocks would have a slightly higher risk premium than the big, established firms that make up the S&P 500.

Which means you might want to rethink just how much you expect your retirement nest egg to be worth when you retire. If your equity investments earn, on average, 1.5 percent less each year, this adds up over time.

Let’s say $50,000 in your 401(k) is invested in large company stocks. If your investment averages 10 percent per year, after 20 years you’ll end up with $336,374. But if it generates an annual return of 8.5 percent, you’ll be looking at $255,602 — $80,000 (24 percent) less.

What can/should you do? There are only about three choices, if you exclude robbing a bank after you retire: 1) reduce the standard of living you were planning on; 2) increase the amount of money you’re socking away; 3) expect to continue working in a reduced capacity.

I know this isn’t exactly happy news. But knowing this in advance hopefully gives you time to do some planning. Look at it this way: if the market does better than expected, you’ll be sittin’ pretty.

Hope this helps,

Gail

*Federal Reserve Bank of Minneapolis

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