What Risk Premium?

More fun from the Ibbotson Yearbook. Here’s a look at large-cap stocks dividend by long-term Treasury bonds, also known as the risk premium (although short-term rates are more often used).

The risk premium is one the most important ideas in finance. In short, it tells us how much you get paid to take on the risk of owning stocks instead of guaranteed government bonds. (Note: According to Ibbotson, the Treasury bond data series is based on a 20-year T-bond.)

I disagree with most mainline thinking on this issue in that I believe the risk premium is much lower than is commonly believed. Most academics think it’s around 5% or so. I think the long-run premium is probably about 2%. Eric Falkenstein thinks it doesn’t exist at all.

According to the Ibbotson numbers, large-cap stocks have outperformed Treasury bonds by an average of 3.93% per year since 1925.


But as the chart shows, that data series is very volatile. Government bonds have outperformed large-cap stocks since November 1980. That’s more than 32 years of no risk premium. Since May 1969, the risk premium has been a grand total of 0.77%. Over the last 12 years, it looks really ugly. Treasury bonds have beaten large-caps by a painful 207% to 24% margin.

Due to the ultra-low yields for Treasuries, I suspect large-caps will outperform bonds by 5% in the intermediate range. The yield on the 20-year T-bond closed yesterday at 2.6%. If we assume a 2% risk premium, that translates to a return for stocks of 7.6%, and that includes dividends which currently run around 2%.

Posted by on April 5th, 2013 at 1:06 pm

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.