Life in the Ivory Tower: Sometimes you just don’t know

August 11, 2012

Glenn Okun pointed me to an entertaining debate between PIMCO’s investment guru Bill Gross and Wharton professor Jeremy Siegel over the merits of investing — now — in equity or bonds.  If you’re interested, try one of these or search their names.  I especially liked Gross’s characterization of Siegel’s views as “Ivory Tower,” suggesting — somehow — that wasn’t a good thing.  What was he thinking?

At the risk of getting the same back, I thought it might be worth reviewing the evidence:   What do we know?  And what don’t we know?  Now you might say that what we know is the past, and what we don’t know is the future, but we can be more specific than that.

Equity pays a premium.  Over more than a century of US history, real returns on equity have been significantly above real returns on government bonds.   Siegel says the difference is 6.6% a year.  I get something like 4.4% a year when I include 2008, but the methods are somewhat different (logs of gross returns, if you’re interested).  Either way, average returns on equity have been higher — on average — than returns on government bonds.

Equity is risky.  The standard deviation of excess returns on the S&P 500 is something like 18% per year.  That means a plus or minus two standard deviation range is, well, huge.  And equity also suffers periodic disasters, like 1933 or 2008.  Some of this averages out if you invest over a long period of time, but it’s clear there’s some risk here.  And if you’re a statistician, you might note that both features reduce the precision of our estimated equity premium.

Sources of risk.  Risks differ in the two markets.  The primary factor in the stock market has generally been the economy.  In the bond market, the central issue tends to be inflation.  Bond returns over the last fifty years are low, on average, largely because low-coupon bonds issued in the 1960s got hammered when inflation picked up in the 1970s.

The future.  No one knows what the next ten years will be like, whatever they might claim.  The economy could boom or stagnate, inflate or deflate.  Let’s face it:  Sometimes we just don’t know.  My money’s on equity, but I’m an optimist.

The classic Ivory Tower advice is the same as it has been since the 1960s:  buy a diversified portfolio adjusted to your situation and risk tolerance, hold it as long as you can, and spend the money you save on fees on something you enjoy.  I’ll be heading to Amity Hall shortly to do just that.  If you stop by, tell them Dave sent you.

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