If you want to capture the equity, size and value premiums, a long-term horizon is crucial.
The stock premium, the annual average return of stocks minus the annual average return of one-month Treasury bills, has historically been high. This fact has, understandably, attracted investors to the stock market.
For the period 1927-2013, the stock premium averaged 8.18 percent. There has also been a size premium (the return of small stocks minus return of large stocks) and a value premium (the return of value stocks minus return of growth stocks) over that same period of 3.06 percent and 4.88 percent, respectively.
However, the excess returns are generally referred to as risk premiums—they aren’t free lunches. We see evidence of this in their volatility. The stock, size and value premiums have come with annual standard deviations of 20.29 percent (2.5 times the stock premium), 12.66 percent (4.1 times the size premium) and 12.79 percent (2.6 times the value premium), respectively.
|Stock Premium (%)||Size Premium (%)||Value Premium (%)|
|Annual Standard Deviation||20.29||12.66||12.79|
Risks In Premiums
Let’s take a closer look at some of the data illustrating the riskiness of the three premiums. For the 87-year period from 1927 through 2013:
The Stock Premium
The stock premium was negative in 28 of those years (or 32 percent of them). There were 16 years (or 18 percent of them) when the premium was worse than -10 percent, 12 years (or 14 percent of them) when it was worse than -15 percent, and seven years (or 8 percent of them) when it was worse than -20 percent.
As another indicator of the volatility of the stock premium, we see that the gap between the best and worst years was 102.1 percentage points, more than 12 times the size of the premium itself. The worst year was 1931, when the premium was -44.98 percent.
Given an overall average premium of 8.18 percent and a standard deviation of 20.29 percent, this was a more than two-standard-deviation event. The best year was 1933, when the premium was 57.12 percent, also more than two standard deviations from the mean. In fact, we had six such two-standard-deviation events. Just four would have occurred if the returns were normally distributed.