Peter L. Bernstein

Bio: Peter L. Bernstein is an academic researcher. The author has contributed to research in topics: Dividend & Lender of last resort. The author has an hindex of 10, co-authored 62 publications receiving 579 citations.

What Risk Premium Is “Normal”?

Abstract: The goal of this article is an estimate of the objective forward-looking U.S. equity risk premium relative to bonds through history—specifically, since 1802. For correct evaluation, such a complex topic requires several careful steps: To gauge the risk premium for stocks relative to bonds, we need an expected real stock return and an expected real bond return. To gauge the expected real bond return, we need both bond yields and an estimate of expected inflation through history. To gauge the expected real stock return, we need both stock dividend yields and an estimate of expected real dividend growth. Accordingly, we go through each of these steps. We demonstrate that the long-term forward-looking risk premium is nowhere near the level of the past; today, it may well be near zero, perhaps even negative.

What Risk Premium is 'Normal'?

Abstract: We are in an industry that thrives on the expedient of forecasting the future by extrapolating the past. As a consequence, investors have grown accustomed to the idea that stocks "normally" produce an 8% real return and a 5% risk premium over bonds, compounded annually over many decades. Why? Because long-term historical returns have been in this range, with impressive consistency. Because investors see these same long-term historical numbers, year after year, these expectations are now embedded into the collective psyche of the investment community. Both figures are unrealistic from current market levels. Few have acknowledged that an important part of the lofty real returns of the past has stemmed from rising valuation levels and from high dividend yields which have since diminished. As this article will demonstrate, the long-term forward-looking risk premium is nowhere near the 5% of the past; indeed, it may well be near-zero today, perhaps even negative. Credible studies, in the US and overseas, are now challenging this flawed conventional view, in well-researched studies by Claus and Thomas [2001] and Fama and French [2000, Working Paper], to name just two. Similarly, the long-term forward-looking real return from stocks is nowhere near history's 8%. Our argument will show that, barring unprecedented economic growth or unprecedented growth in earnings as a percentage of the economy, real stock returns will probably be roughly 2-4%, similar to bonds. Indeed, even this low real return figure assumes that current near-record valuation levels are "fair," and likely to remain this high in the years ahead. "Reversion to the mean" would push future real returns lower still. Furthermore, if we examine the historical record, neither the 8% real return nor the 5% risk premium for stocks relative to government bonds has ever been a realistic expectation (except from major market bottoms or at times of crisis, such as wartime). Should investors require an 8% real return, or should a 5% risk premium be necessary to induce an investor to bear stock market risk? These returns and risk premiums are so grand that investors should perhaps have bid them away a long time ago - indeed, they may have done so in the immense bull market of 1982-1999. Intuition suggests that investors should not require such outsize returns, and the historical evidence supports this view. This is a topic meriting careful exploration. After all, according to the Ibbotson data, investors earned 8% real returns over the past 75 years, and stocks have outpaced bonds by nearly 5% over the past 75 years. So, why shouldn't investors have expected these returns in the past and why shouldn't they continue to do so? Expressed in a slightly different way, we examine two questions. First, can we derive an objective estimate of what investors should have had good reasons to have expected in the past? And, why should we expect less in the future than we've earned in the past? The answers to both questions lie in the difference between the observed excess return and the prospective risk premium, two fundamentally different concepts that unfortunately carry the same label, "risk premium." If we distinguish between past excess returns and future expected risk premiums, it is not at all unreasonable that the future risk premiums should be different from past excess returns. This is a complex topic, requiring several careful steps to evaluate correctly. To gauge the risk premium for stocks relative to bonds, we need an expected real stock return and an expected real bond return. To gauge the expected real bond return, we need both bond yields and an estimate of expected inflation through history. To gauge the expected real stock return, we need both stock dividend yields and an estimate of expected real dividend growth. Accordingly, we go through each of these steps, in reverse order, to form the building blocks for the final goal: an estimate of the objective, forward-looking equity risk premium, relative to bonds, through history.

Points of Inflection: Investment Management Tomorrow

Abstract: In the future, the way investment professionals earn a living is going to be so different as to be almost unrecognizable.

The Capital Asset Pricing Model: Theory and Evidence

Abstract: T he capital asset pricing model (CAPM) of William Sharpe (1964) and John Lintner (1965) marks the birth of asset pricing theory (resulting in a Nobel Prize for Sharpe in 1990). Four decades later, the CAPM is still widely used in applications, such as estimating the cost of capital for firms and evaluating the performance of managed portfolios. It is the centerpiece of MBA investment courses. Indeed, it is often the only asset pricing model taught in these courses. The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor—poor enough to invalidate the way it is used in applications. The CAPM’s empirical problems may reflect theoretical failings, the result of many simplifying assumptions. But they may also be caused by difficulties in implementing valid tests of the model. For example, the CAPM says that the risk of a stock should be measured relative to a comprehensive “market portfolio” that in principle can include not just traded financial assets, but also consumer durables, real estate and human capital. Even if we take a narrow view of the model and limit its purview to traded financial assets, is it

The Strategic and Tactical Value of Commodity Futures

Abstract: Investors face numerous challenges when seeking to estimate the prospective performance of a longonly investment in commodity futures. For instance, historically, the average annualized excess retu...

False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas.

Abstract: Standard tests designed to identify mutual funds with non-zero alphas are problematic, in that they do not adequately account for the presence of lucky funds. Lucky funds have significant estimated alphas, while their true alphas are equal to zero. To address this issue, this paper quantifies the impact of luck with new measures built on the False Discovery Rate (FDR). These FDR measures provide a simple way to compute the proportion of funds with genuine positive or negative performance as well as their location in the cross-sectional alpha distribution. Using a large cross-section of U.S. domestic-equity funds, we find that about one fifth of the funds in the population truly yield negative alphas. These funds are dispersed in the left tail of the alpha distribution. We also find a small proportion of funds with truly positive performance, which are concentrated in the extreme right tail of the alpha distribution.

Three-month-old infants' reaction to simulated maternal depression.

Abstract: To investigate the nature of the young infant's social competence, the effect of depressed maternal expression during face-to-face interaction was examined using an experimental analogue of maternal depression. Subjects were 12 female and 12 male infants, ages 96-110 days, and their mothers. 2 counter-balanced experimental treatments consisted of 3 min of normal maternal interaction and 3 min of stimulated depressed interaction. A control treatment consisted of 2 3-min epochs of normal maternal interaction. Interactions were videotaped and infant behavior described on a 5-sec time base that maintained order of occurrence. Infants in the depressed condition structured their behavior differently and were more negative than infants in the normal condition. Infants in the depressed condition produced higher proportions of protest, wary, and brief positive. Infants in the depressed condition cycled among protest, wary, and look away. Infants in the normal condition cycled among monitor, brief positive, and play. In addition, differences in negativity were likely to continue briefly after mothers switched from depressed to normal interaction. The data indicate that infants have a specific, appropriate, negative reaction to simulated depression in their mothers. These results question formulations based on alternate hypotheses and suggest that the infant has communicative intent in its interactions.