The US equity premium puzzle, by Publius
Since records began in 1926, an investor in a value-weighted basket of all US listed stocks has made between 4-8% annual return in excess of the risk-free return on US government Treasury Bills. At present, despite the recent downturn, to the end of 2021, that number stands at the higher end at 8%. If you start the record in 1946 instead of 1926 it is still 8%. This is the US stock market equity premium.
Now 8% per annum in excess of the interest rate on riskless investments is enormous. Imagine your grandparents, or great-grandparents if you’re young enough, had had the foresight to invest $1,000 in stocks back in 1926 for your benefit. That sum would have been worth just over $1.6 million today in excess of what they’d have made if they’d put it in T-bills. Even in 1926, plenty of folks had $1,000 to put aside for their descendants.
Inflation doesn’t come into it, because inflation eats up both equity returns and T-bill returns, so the excess is inflation-neutral. That 8% is real. It is said that J.P. Morgan never turned down 10% real, so even he would have been moderately satisfied with probably the least demanding investment of all time: The Index.
Today you can invest in what almost exactly corresponds to the Index through index funds, some of which are so large they’ll charge you zero to do so (they make it up by lending your stocks to short-sellers and gaining stock lending fees). Why doesn’t everyone in the world invest in index funds and then sit back and relax for their whole lives?
There are too many different answers to that last question to cram into one short article (None are satisfactory.). A bigger issue is that the US equity premium is puzzling because it’s much too big. It’s quite true that US stock markets are volatile, and we’re seeing that at the moment, but that isn’t really a solution, because when US stock markets tank, it turns out that US firms, households and governments sail serenely on, and the market soon gets back on its feet. For a long-term investor with income from a job, US stocks just aren’t risky at all, apparently. Then 8% looks like a very good deal indeed for anyone who is willing to take the long-term view. It’s a deal open to almost anyone in the world these days with $1,000 (or even $10). And it’s free.
The equity premium puzzle doesn’t strike one as that puzzling at first. After all, we’re talking about investing in stocks, for heaven’s sakes, which are very risky. That is true, but a diversified basket of stocks covering the whole economy is much less risky than individual stocks. Every time a Google destroys a Yellow Pages, index investors don’t care because they own both. They benefit from the progress made to the whole economy and society from doing things much more efficiently and productively with the gains to the winners almost always vastly exceeding the losses to the losers. Again: Index investing just isn’t that risky.
There are two clouds on the horizon that might change that view, but I don’t worry much about either. First, big, successful businesses are staying private more often than they used to. In fact, Google destroyed the Yellow Pages while it was still a private company, so investors in the index would have lost their money in the latter while failing to gain from the former (thought you had me there, I betcha!). But increasingly there are funds in the index which hold private equity in `early’ stage firms like Google before they go public so you can get into them before they go public, because those funds are themselves in the index. That will turn out to have been a short-term anomaly in the period 2000-2015 and is now over. The index will get you into those amazing pre-listing firms these days. For example, you can invest in SpaceX, an unlisted firm, through a variety of vehicles which are themselves listed and open to the general public.
The second cloud is catastrophe: The planet may die from climate change, the Russians might nuke us all, the Chinese might too etc etc. But here’s the point: Catastrophe will wipe out bondholders too. So only an idiot would invest in T-bills or other US debt if they worry about catastrophe. Stocks are the answer. Some stocks might even do well!
The brilliant and awesome process of creative destruction unleashed at some point in England in the 18th century and then perfected by the US (and maybe even China these days) can only be harvested for the profit of ordinary folks through index investing. That process is safe. So, here’s a radical proposal for a Republican administration.
For every child born in the US from this day forward entitled to a Social Security Number, put $1,000 on the day of their birth into an index fund for them to collect the day they turn 65 (or 70 if the retirement age increases in future). If they die before that age, roll it over to their heirs, free of any stupid taxes. On retirement, within 65 years, every American will be a millionaire in today’s dollars and able to live comfortably through their old age without any need to pay social security. In addition, every American will have a strong incentive to work hard and support their country, sure in the knowledge that their payout will be massive. Let’s finally allow everyone to bet on America for their whole lives. Even if people you dislike (such as Democrats) win the odd election, you won’t start a civil war because you know your trust fund is growing. Hedge it with a Constitutional Amendment so no damn politicians can touch it for their nefarious purposes. And above all let the private sector run it so that fees are kept at zero or even negative.
Cost? There were 3.7 million babies born in the USA last year, so my proposal would cost $3.7 billion ONCE (for those kids). Total social security contributions in 2021 were $1,001 billion PER YEAR in 2021, according to the Social Security Administration, and it’s in deficit! If you’re worried about stock market volatility in the final years before retirement then by all means start shifting that person’s trust towards more stable T-bills. Norway did this years ago. Let’s do it. It’s a free lunch, because we have a great, deep and liquid stock market.
It's a simple long-term solution to all our problems with social security. I wish all such problems were so easily solved.