There’s nothing new under the sun in the money game, but there’s always a fresh perspective. Sometimes that makes all the difference. Sometimes that’s all there is.
In the quest to offer something productive, let’s imagine that reviewing the whys and wherefores of risk premia can help sober us up about what’s necessary to keep the red ink at bay and maybe, just maybe, turn a profit with a multi-asset class portfolio.
For those who are interested in the details, including a broad review of the academic literature and the empirical record, you’re in luck. Your intrepid editor has a book coming out next month from Bloomberg Press—Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor. We also analyze the markets, portfolio strategy, and otherwise crunch the numbers on a monthly basis for subscribers to The Beta Investment Report. As for the aforementioned investment perspective, allow us to take you on a brief (very brief) tour.
As readers of these digital pages know, we begin with the market portfolio, broadly defined. A reasonable proxy for most investors can be modeled on a global mix of stocks, bonds, REITs and commodities, weighted by their respective market values. In fact, we do just that by calculating our Global Market Index, the benchmark for The Beta Investment Report.
GMI is hardly a silver bullet, but it’s a powerful place to start for considering asset allocation and how to customize portfolios to satisfy each investor’s expectations, risk tolerance, investment horizon, etc. For perspective (there’s that word again), financial economics tells us that the unmanaged market portfolio a la GMI is the optimal portfolio for the average investor for the very long run. The question, then, is how you and I are “different” from the average investor. Although definitive answers are elusive, everyone should spend some time thinking about how to respond and what that implies for designing and managing a portfolio.
Unsurprisingly, we spill a good deal of ink on the topic in the book and in the newsletter. As this is billed as a “brief” tour of strategic investing perspective, however, let’s skip over this question here and move right to the red meat of money management: risk premiums, or the return generated by securities and asset classes over and above a risk-free rate, such as a 3-month Treasury bill. The details on risk premia can get tangled, not to mention voluminous, and so we’ll (again) favor an absurdly concise treatment here, starting with the question: Why do you expect to earn a premium in, say, stocks relative to T-bills?
The basic answer, of course, is risk, ergo the term risk premium. An obvious if circular answer, perhaps. But this simple framework is worth pondering for a moment. Why is there a risk premium? Why should it exist? Again, the answer is quite long, but on very simple level we can begin by recognizing that risk premia are linked with uncertainty. There are other factors involved, but some degree of risk premia are a function of uncertainty. When you buy a stock or an index fund that represents the equity market, you’re purchasing shares with the view that the economy will grow (eventually), earnings will rise (hopefully), and so your investment will increase in price (let’s assume). History, at least, offers some context for embracing this connection.
But we can’t be sure of this rosy outlook, particularly in the short run. The economy might contract between now and next year; earnings might fall; equity prices might decline. The expectation of earning a risk premium is in some sense a compensation for bearing this uncertainty.
This is a good point to mention as well that expected risk premiums vary. Sometimes the equity risk premium, for instance, is relatively high; sometimes it’s relative low. Usually, it’s middling. In any case, it’s far from static. Why? Because the level of uncertainty varies too, or at least the perception of uncertainty does.
That’s largely a byproduct of the fact that there’s a thing called the business cycle. To cite the extreme case, at the height of a financial crisis in the middle of a deep recession—late-2008, for instance—uncertainty is extraordinarily high. Will the economy collapse? Or will it rebound? Will the economic world as we know it end next week? Or will stability eventually return?
Normally, such life-and-death questions aren’t topical for making investment decisions. But sometimes, those are the only questions in town. Investors are consumed with a “yes” or “no” response. At such moments when the economic landscape is simple—survival or death—so too is the level of uncertainty unusually high. Why would anyone buy stocks, or an equity index, at such a time? The expected risk premium is extraordinarily high. And, yes, somebody was buying securities in late-2008.
By contrast, expected risk premiums are usually rather bland, relative to the long run of history. That’s not surprising. If there’s no obvious death threat hanging over the economy, you shouldn’t expect to receive an unusually rich level of compensation for holding risky assets.
Of course, let’s also recognize the existence of the opposite extreme. When everything seems to be going well, and the crowd believes that the future is rather transparent in terms of the view that the good times will roll on, the expected risk premium is modest if not thin. It may even be MIA. Again, no great surprise.
There’s a caveat, of course, which is that estimating expected risk premiums is somewhat precarious. Arguably it’s easier at extreme points, such as in late-2008, when bearish sentiment was exploding. Similarly, when the bulls are on steroids, as in late-1999, our confidence is somewhat higher for predicting a relatively low risk premium for equities. Arguably it’s also easier to projectc risk premiums if you’re looking out over relatively long stretches of time.
Alas, our confidence in the task of projecting risk premia is always, always well below 100%. Yet the confidence level fluctuates, as do expected risk premia, and to some degree we should attempt to exploit such fluctuations a la dynamic asset allocation. But ultimately we’re never fully sure what’s coming, which inspires various risk-management techniques, starting with a cautious stance on straying too far from the market portfolio a la our Global Market Index or something comparable without a compelling reason. We can also apply some simple applications to minimize uncertainty’s blowback, such as regular/semi-rebalancing of the asset allocation. In addition, perhaps we can engage in forecasting of one kind or another, based on what financial economics has taught us over the years.
Ultimately, there’s no cure for uncertainty, which is to say there’s no free lunch. That’s why the financial gods invented risk premia. Is all of this unpersuasive? If so, there’s another alternative—avoid risk altogether. There are, in fact, several choices of assets with expected risk premiums forever set at zero. Or perhaps you’re inclined to own some of each, i.e., cash and risky assets. Choices, choices.