Does A Lower Equity Premium Mean Lower Allocations To Stocks?

There are many people who have built seemingly compelling cases for a lower equity premium for the future (“equity premium” is the difference in return over the long term of stocks versus the “risk free rate” which is usually the return on treasury bills or cash). But does that mean that people shouldn’t put money into the stock market?

I would argue that so long as capitalism still works, then the overall capital markets will always adjust so that on average it makes sense for enterprises to borrow money in the expectation that they can invest the proceeds into productive endeavours that will earn them a higher rate of return than the interest they are paying on their debts. If this relationship were to fall apart over long periods of time – we have much bigger problems to deal with (i.e. your portfolio would be the last thing on your mind.) If this were to happen, then there would be no incentive to create and maintain businesses.

Of course, if theory doesn’t help you sleep at night, you could consider conservative option strategies, higher allocations to fixed income and cash or dangerous hobbies.

For the real theorists, refer to my post about “the cost of capital being the investor’s expected return“.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 3 comments
  • Michael James

    I have always found this “owners vs. lenders” argument to be compelling. To see it this way, you have to step back for the 1000-foot view (300-meter view?). If owners stop borrowing, then lenders must lower their rates to attract borrowers. It’s easy to get caught in a micro view looking at your stock and bond returns and fearing that bonds will outdo stocks indefinitely. But the macro argument says that this isn’t possible.

  • Mark Wolfinger

    Preet,

    ‘Dangerous hobbies.’ I congratulate you on a very original thought.

    Regards

  • Preet

    @Michael James – that’s a much simpler way of saying it then what I came up with – thanks! :)

    @Mark Wolfinger – it’s the financial planning option no-one offers to clients… :)