Sunday, March 30, 2008

What if the equity premium is not there?

An important thought piece in the Sunday NYT was written by Peter Bernstein “When the long view isn’t so scenic”. http://www.nytimes.com/2008/03/30/business/30view.html?ref=business

The most important orthodoxy in finance for the last 25 years has been the essential need to hold stocks for the long-run. This is based on the historical equity risk premium which shows that investors have been paid handsomely for holding stocks. When in doubt, hold a good allocations in stocks (2/3rds equity and 1/3rd fixed income or other). If you have doubts about what you should do with your portfolio, don’t worry, just hold onto your equities and you will be fine. Yes, you will see ups and downs in any given year, but the best allocation policy is to put them away and not worry about the day-to-day fluctuations.

But what if this view is wrong? What if we are going to be in an extended period of poor performance for the equity markets and the equity premium is not there? This does not mean that you will not be paid for taking risk, bu the idea of holding stocks as the best return to risk may not be present over the next few years. Of course, this will mean that any recession will have a long life. Stagflation will be with us for some time and may get worse. Of course, the assumption for many allocators is that since we do not know the future we should hold stocks as the base position.

For many baby-boomers the next twenty years may be the most important, yet what is the alternative. Fixed income has a negative real yield. Cash is no better. The glamour of hedge funds is gone. The case for stocks may be based on the lesser of alternative evils. It certainly is not a time to reach for riskier asset. Or is it? Perhaps this is the time when you are paid for taking risk, but the issue is where you should find these opportunities an holding a stock index may not be the solution.

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