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Reflections on the equity risk premium and the Reversion of returns to the mean

Investors  attempt in the medium/ long term to take advantage of the extra returns generated by participating as shareholders in the selected companies of their portfolios. Taking non diversifiable Risk is eventually compensated by higher returns. In addition, as the investment horizon expands returns  exhibit a behavior observed in many aspects of life : a reversion to the mean.

In the tables here below we can note :

A) equities outperform fixed income in three out of four cases in terms of yearly returns providing a nominal return above 10pct (about 7 pct real ).  In five year periods they outperform nine out of ten cases. The outperformance becomes extreme as the investment horizon expands (Table2)

B)  in the long run (50 year periods) equities outperform bonds by more than 4-5 pct  and TBills by more than 7pct.(Τable1) 

C) Variability presented  in one year returns decreases over all possible five year periods and even more over ten year periods. Thus excessive deviations from the norm of the one year returns is substantially decreased as the investment horizon expands. We can note the decreasing standard deviation over five and ten year periods in table 1.

In addition we would like to note from several other studies :

D) Most  one year observations (about 90 pct ) are out of the range of 8-12 pct returns ( mean plus or minus one standard deviation).  The distribution of returns appears wider than the implications from a normal distribution. Extreme returns are more likely in practice.

E) in the long run equities are a better hedge than fixed income  against inflation. Indeed they present claims against the real assets of companies.  However, in the shorter run they provide less effective protection against inflation 

The future evolution of events can surprise even the wise consensus.  As a consequence,  Volatility is the outcome of the discrepancy between anticipations and realizations. Volatility increases if serious  shocks occur that are exogenous to the economic system, °like political shocks, disputes, wars, epidemics etc

We do not forget that :

‘ the Interpretation of the past is done by humans, of the present by the wise ones and of the future by the gods ! ‘

However, we have more certainty in our medium/ long term projections.

We believe that Investors should focus on the medium/ long term equity risk premium of 4 to 7 pct and its regression to the mean. Additionally, in an effort to enhance returns they could use a part of the portfolio for trading. They can rely on fundamental and technical analysis that involve in essence the effort to prove  that in the short run the consensus of market participants is wrong.  Nevertheless, history teaches us that the main part of the  portfolio should stay invested.

This long term strategy will almost certainly  help the bank account although volatility might create short term problems … in the stomach !

Best wishes,