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For an old market mystery, a 50 percent solution

Mutual-fund investors have come up with a pretty fair solution to a puzzle known as the equity market premium.

They probably don't think of it in those exact terms. The long-running academic debate on the subject may never have reached their ears.

But as any host to a rhinovirus can testify, you don't have to know the technical name for something to engage with it in everyday life. Among investors, the equity-premium conundrum may be as familiar as the common cold.

The puzzle, in a nutshell, is this: For the last several generations, stocks have provided much bigger payoffs than their chief competitors, bonds and money-market securities. Once investors see this, why have they let it keep happening? Why don't they bid up stocks once and for all to a point where the returns are more comparable?

Look at the record. According to data from Ibbotson Associates Inc., large-company stocks returned 10.4 percent a year from 1925 through 2003 -- almost twice the 5.4 percent annual return for government bonds, and almost three times the 3.6 percent return for short-term Treasury bills. Inflation came in at 3 percent a year.

If life conformed to some purely rational model, the markets should have long since corrected for this disparity -- unless stocks are, oh, twice as risky as bonds and three times as risky as T-bills.

Wild Ride

Well, that is true in the short term, as has been shown with crystal clarity of late. In the last five calendar years, the Standard & Poor's 500 Index has been up 19.5 percent; down 10.1 percent, down 13 percent; down 23.4 percent, and up 26.4 percent.

Stocks' partisans always remind us that a lot of the variability evens out over longer periods. In the woebegone 1970s, for instance, when the index suffered back-to-back declines of 17.4 percent in 1973 and 29.7 percent in 1974, it still finished the decade with a total return, including dividends, of 5.8 percent per year.

And long-term goals, such as providing for retirement and children's education, are why many people invest in stocks. So those people must be letting short-term volatility scare them away from the best available long-term rewards.

Or maybe not, argues Benoit Mandelbrot, mathematics professor at Yale University, in his mind-stretching new book ``The (Mis)Behavior of Markets.'' If I'm bold enough to paraphrase his argument, he says investors rightly see the extremes of stock prices as manifestations of a dangerous turbulence that cannot be blithely averaged away.

Street Smart

"Real investors know better than the economists," he writes. "They instinctively realize that the market is very, very risky -- riskier than the standard models say," he says. "The same reasoning helps explain why so much of the world's wealth remains in safe cash, rather than in anything riskier."

U.S. mutual-fund investors fit right into this picture. At last report from the Investment Company Institute, fund owners had just a shade more than 50 percent of their $7.4 trillion in stock funds; about 27 percent in money-market funds, and about 23 percent in bond and hybrid stock-bond funds.

Now, it's a judgment call whether this is too much or too little of any given asset class. Other readers of Mandelbrot might say a 50 percent stocks solution is still too strong.

To me it looks like a reasonably diversified position, given that shying away from growth investments in pursuit of long-term goals also is a risky thing to do. No, 50-27-23 isn't the three-legged stool we saw back in the early 1990s, when fund assets were allocated almost evenly in thirds.

Different Story

Then again, interest rates are much lower now. The yield on the 10-year Treasury note, recently hovering just around 4 percent, hit 8 percent in 1994.

Also, more than a third of mutual-fund money is now invested through retirement plans such as 401(k)s, where money-market funds are seldom recommended. A decade ago such defined- contribution retirement plans were much smaller.

The next time stocks hit a bad patch, will some fund investors howl in pain? You bet they will. Some will find, as happened in the 2000-02 bear market, they possess less tolerance for stock risk than they thought.

In the aggregate, though, fund investors aren't doing so badly balancing risk against reward. They see growth as a necessary element of a long-term investing plan. The way they have deployed their money attests that they also have a continuing sense of how risky investing for growth can be.


Currier is a Columnist for Bloomberg News. Comments regarding this piece can be sent to editor@sddt.com. All letters are forwarded to the author.

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