Modern portfolio theory holds that investors get paid extra return for taking risk. The concept is simple, but can be hard to implement without coaching and education, and it grew more important lately: Investors who take equity risk expect to earn extra return.
To quantify the risk premium of stocks, the amount you get paid for owning a risky asset, according to modern investment theory, here are the numbers: Over the 23 years ended on December 31, 2020, the risk-free 90-day U.S. Treasury bill averaged an annual return of 1.86%, compared to the 8.08% annualized return on the Standard & Poorâ€™s (S&P 500) stock index. By subtracting the 1.86% return on the no-risk asset from the 8.08%, the resulting 6.22% annually earned on stocks over the boom-and-bust cycles since 1998 represents the equity risk premium.
To be clear, owning stocks through the tech bubble in 2000, financial crisis in 2008 and 2009, and COVID bear market rewarded investors with a premium of 622 basis points over what they would have earned by investing in a risk-free 90-day Treasury.
The equity risk premium fattened considerably in the last quarter, moving from 5.75% to 6.22% as the return on stocks improved while the 90-day Treasury bill remained incredibly low. Low Treasury bill rates and the $900 million federal economic stimulus and relief aid enacted in December have created a mountain of cash, driving up stock prices.
This chart better illustrates the risky aspect of the equity risk premium. The red data series shows the daily changes in the stock market prices, as represented by the S&P 500. Big one-day drops of between -3% and -5% are not uncommon in recent months, and, earlier in 2020 , stocks plunged -12% in a single-day! So, indeed, earning the equity risk premium is hard and scary at times. Armed with these kinds of statistics, which show that big daily plunges do come frequently, may make it easier to withstand the uncertain times.
With the COVID outbreak continuing and the worsening hospitalization rate across many states, the risk of a stock market plunge should have been expected, but retirement investors â€“ permanent investors who plan to own stocks for the rest of their lives â€“ were wise to view volatility as a friend. That's a different way of looking at the world, but it absolutely is valid.
Choosing to expose a portion of your portfolio to price volatility, also known as risk, enables you to earn a better return over the long run. You wouldn't earn the six-percentage-point equity risk premium in stocks if you weren't exposed to lots of volatility. It just goes with the territory. Itâ€™s part of owning a risk asset.
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