May 2003
Risky Business
| "Great deeds are usually wrought at great risks." |
| --Herodotus |
HE BEAR MARKET HAS DRIVEN A LOT of investors out of the stock market. Many vow to return when it's not so risky, but what does that really mean?
First of all, it implies stocks got riskier, or are at least riskier now than they will be at some point in the future. Are stocks really riskier than a few years ago or even decades ago?
Secondly, if investors really want to come back to stocks when they're less risky, does that mean potential returns are too high now? That would seem to follow since there's a direct relation between risk and return. If risk is high now, so are potential returns. If investors want to avoid the extra risk, they must also want to avoid the extra potential return.
Does any of this make sense? It actually might, but it takes a little sorting out.
Risk? What Risk?
Let's start by getting a handle on risk. You've heard at least a thousand times that those who are willing to take greater risks are rewarded with the opportunity to achieve greater returns. You also know that stocks are riskier than bonds and bonds are riskier than cash investments, therefore on average, bonds have higher returns than cash and stocks have higher returns than bonds.So by simple virtue of the fact that equity investors buy stocks, they automatically take on more risk than those who hold only fixed income. So those waiting for stocks to become less risky, must think equities are currently riskier than normal.
OK, so what's normal? In order to answer that, you have to quantify risk in some manner.
A good place to start when considering risk relative to other types of securities is the so-called "Equity Risk Premium." Ibbotson and Associates defines this as, "the geometric difference between S&P 500 total returns and U.S. 30 Day Treasury Bill total returns," basically the additional return from large cap stocks over the risk-free rate.
Chart 1 shows the monthly Equity Risk Premium over the past three-quarters of a century. The first thing that jumps out is the fact that it does fluctuate pretty dramatically -- at least in the short-term.
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Chart 1 U.S. Equity Risk Premium January 1926 - March 2003 |
 Source: Ibbotson Associates |
The second thing to notice is that this "premium" can be negative as has been the case in the past three years when stocks lost ground. Over long periods of time (January 1926 - March 2003) however, the Equity Risk Premium has averaged 8.13% a year.
The next, and possibly the most important thing for our purposes here, is to compare the risk premium's levels to those of previous periods. Have they grown considerably greater?
From Chart 1, it's hard to say, at least quantitatively. It does appear that premium was much greater -- both positive and negative -- in the 1920s as well as from 1973 - 1992. Were stocks riskier then?
Maybe, maybe not. The simple fact that the Equity Risk Premium rises doesn't necessarily mean stocks have gotten more risky, but rather that the difference with the T-Bill has grown. Risk typically measures the chance of an actual return on investment differing from its expected value.
Given that, it would be more informative to consider the degree of change in the Equity Risk Premium rather than the actual period values themselves. This is a fairly common way to measure risk and is called the standard deviation.
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Chart 2 U.S. Equity Risk Premium Periodic Average Values January 1926 - March 2003 |
 Source: Ibbotson Associates |
Generally the greater the standard deviation -- the average variation from the expected return -- the greater the risk. This makes sense if you think about it since returns of investments with greater standard deviation are more likely to differ from the expected value.
Chart 2 compares periodic values of the Equity Risk Premium to its standard deviation. The green bars, with the exception of the first and last, show the average Equity Risk Premium for each decade starting with 1930 and ending with 1999. The first bar covers the four years from 1926-1929 while the final bar covers the period 2000-2003.
The gray bar shows the average premium for the first three months of 2003 while the red bar shows the average for the entire period 1926-March 2003. The line graph shows the average's standard deviation over the same periods.
Judging from Chart 2, risk certainly hasn't increased recently. Looking at average values, the Equity Risk Premium has been all over the board, but the standard deviations tell a different story.
Ever since the decade of the 1940s, the standard deviation has held fairly steady, around 15%. The average for the entire period is actually higher (~20%) but it's somewhat distorted by the excessive value from the 1930s.
What's important here however, is that the standard deviation has fallen precipitously in 2003. Not only is it well below the total average, it's also well under the values of the past sixty years. Based on this, one might argue that equities are actually less risky now.
Risk of What?
Of course very few investors think of risk in terms of return relative to Treasury Bills. Perhaps they should, but most folks think of risk in relation to absolute returns. Since that's the case, are stocks now more risky in that regard?Chart 3 shows actual returns and standard deviation of the S&P 500 over the same periods as Chart 2. Yes, it's a different chart although it looks almost identical. Does that tell you something?
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Chart 3 S&P 500 Returns and Standard Deviation Periodic Average Values January 1926 - March 2003 |
 Source: Ibbotson Associates |
It stands to reason that the actual return of the index would closely follow the fluctuations in the Equity Risk Premium. It also makes sense that the standard deviations are similar as well. But again, if risk is measured by standard deviation, it's actually lower now than back in the 1990s.
So are investors just wrong about the current level of risk? Is it simply a convenient excuse to avoid equities? We would suggest not, although the reason is difficult (if not impossible) to quantify.
Look back at Charts 2 and 3, paying close attention to the most recent periods. What jumps off the charts at you? How about the fact that both the Equity Risk Premium and the actual return of the S&P 500 have both been negative?
That certainly hasn't been the case in any of the ten-year periods. Even in the decade of the 1930s, the Great Depression, both were positive.
We've pointed out before that investors really aren't always totally rational as envisioned by Modern Portfolio Theory. Instead, they are often motivated by emotion and perception rather than by logical risk/return optimization.
Under Modern Portfolio Theory, investors are presumed to be risk averse. In reality, that seems to be true when there's a substantial risk of loss, but that's not the case when there's a strong possibility that returns will actually be above average.
Consider the case where it's quite likely that this year's equity return won't be much above that of a Treasury Bill, or perhaps it might even be less than that of the Bill. In this situation it seems reasonable that a rational investor would shun stocks and instead prefer the T-Bill.
But what about the case where it's quite likely this year's equity return will be considerably greater than that of the Bill? Wouldn't stocks be the reasonable choice in that situation? As in the first case, risk is above average, but now it's a good, thing.
If this is correct, then contrary to the basic assumption of Modern Portfolio Theory, investors aren't risk averse, they're loss 
averse. The deviation from the average may be the same in both examples, but when it's negative, investors view it as risk whereas they view it as an opportunity when it's positive.
Which brings us back to the risk in today's equity market: Is it indeed greater now than in the past? Ever since 1999, the Equity Risk Premium has been negative. Over the same period, average annual stock returns have been negative as well. For a loss averse investor, that's pretty "risky".
Of course there's no guarantee than this year's Equity Risk Premium or stock return will be negative. The fact that this was the case for the preceding three years doesn't increase this probability. In fact one could argue that the economy and corporate balance sheets have improved over the past three years, suggesting similar improvement in equity returns.
Nevertheless, investors tend to project current conditions forward into the future. That's why they flooded into stocks when they were peaking in 1999 and why they avoid them now when they're much more fairly valued. It's a common assumption that the current trend will continue indefinately.
The belief that stocks offer a high probability of loss this year leads to the perception that they are riskier now than in the 1990s when their well-above average returns would have said otherwise. If the perceived chance of loss is greater now, then most investors will believe risks have increased.
No, these beliefs aren't rational and they can't be quantitatively justified; yet they do motivate investors to action -- or in this case to inaction. In a totally rational world where standard deviation defines risk, equity risk has not increased; in fact it may have actually fallen. But in the real world, where investors are moved both by logic and emotion, perceived risk has increased. Even quants have to accept that.
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