Swedroe: The Volatility Of Premiums

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.

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.

The Size Premium

The size premium was negative in 38 of those years (or 44 percent of them). There were eight years (or 9 percent of them) when the premium was worse than -10 percent, four years (or 5 percent of them) when it was worse than -15 percent, and two years (or 2 percent of them) when it was worse than -20 percent.

The worst year was 1929, when the premium was -32.59 percent, very close to a three-standard-deviation event. The best year was 1967, when the premium was 42.42 percent, in fact a three-standard-deviation event. The gap between the best and worst years was 75.01 percentage points, almost 25 times the size of the premium itself. We had five years when returns were more than two standard deviations from the mean.

The Value Premium

The value premium was negative in 33 of those years (or 38 percent of them). There were 10 years (or 11 percent of them) when the premium was worse than -10 percent, five years (or 6 percent of them) when it was worse than -15 percent, and two years (or 2 percent of them) when it was worse than -20 percent.

The worst year was 1999, when the premium was -26.79 percent, a more than two-standard-deviation event. The best year was 2000, when the premium was 37.69 percent, also a more than two-standard-deviation event. The gap between the two was 64.48 percentage points, more than 13 times the size of the premium itself. We had three years when returns were more than two standard deviations from the mean.

Extending The Time Frame

Even if we extend our time frame to five-year periods, we see that there is still risk in the premiums. Using nonoverlapping data, we can put together a total of 17 such five-year intervals.

• There are four periods (or 24 percent of them) when the stock premium was negative. The worst period was 1927-1931, when the stock premium was -46.13 percent.
• There are six periods (or 35 percent of them) when the size premium was negative. The worst period was also 1927-1931, when it was -30.2 percent.
• There are four periods (or 24 percent of them) when the value premium was negative. The worst period was again 1927-1931, when it was -30.49 percent.

If we extend our time frame again, this time to 10 years, we can construct eight nonoverlapping periods. In this instance, there were no periods when either the stock or value premiums were negative, but two periods when the size premiums were negative: 1947-1956, when it was -27 percent, and 1987-1996, when it was -14.9 percent.

Using data from 1963 through 2011, professors Eugene Fama and Ken French found that assuming normal distributions (and stock returns aren’t normally distributed) the probability of a negative stock premium fell from 37.0 percent for a one-year period to 22.8 percent for 5 years, 14.6 percent for 10 years, 4.8 percent for 25 years and 0.9 percent for 50 years. In other words, looking forward, there is almost a 1-in-4 chance that the average premium for a five-year period is negative.

Even at 25 years, there is still almost a 1-in-20 chance that the realized average equity premium is negative. It takes a long investment lifetime, 50 years, to reduce the probability of a negative realized average equity premium to only 0.9 percent.

Even if we knew in advance the premium and the volatility (which we obviously cannot), there would still be a 5 percent chance that, over a 25-year period, the riskless one-month Treasury bills would have a higher average annual return than risky stocks. Fama and French found similar results for the size and value premiums, and concluded that this is simply the nature of risk.

The Price You Pay

If you want to earn the expected premiums, you must accept the fact that you will experience losses, no matter how long your horizon. An “expected” premium refers to the mean of the distribution of potential outcomes. Said another way, if you can’t stand the heat, stay out of the kitchen.

It’s also important to understand that we cannot be certain of the risks associated with these premiums. That should make us much less confident about earning them, because the odds of not doing so may well be higher than our estimates.

In other words, at best we can only estimate the odds of experiencing negative premiums, we cannot fully know them. That helps explain why the premiums are large. Investors don’t like uncertainty. Even more, they dislike owning assets that tend to do poorly during bad times, when their labor capital may be at risk. And that’s exactly when the three premiums tend to turn negative.

Diversification Of Risk

There are two more important points we need to cover, both related to the diversification of risk. First, the odds of earning the premiums are based on portfolios that are highly diversified. For more concentrated portfolios—such as those of the typical actively managed fund or the typical individual investor buying individual stocks—uncertainty about outcomes is higher. That is another reason active investing is called the loser’s game.

Second, there is very low correlation of the three risk premiums. The annual correlation of the size and value premiums to the stock premium has been just 0.38 and 0.09, respectively. The annual correlation of the size and value premiums is close to 0 (0.06). That makes them effective diversifiers of portfolio risk, a type of diversification not achieved by those investors who invest only in total market portfolios in their equities allocation.

It’s true that total market portfolios own small and value stocks, providing positive exposure to the premiums. However, they have no net exposure to the size and value premiums because their holdings of large and growth stocks provide negative exposure to the premiums—exactly offsetting the positive exposure provided by the small and value stocks.

Preparation Is Crucial

The bottom line is that when developing your investment policy statement, you must be sure that your portfolio doesn’t assume more risk than you have the ability, willingness and need to take. You must also be sure that you understand and accept the nature of the risks you are going to have to live with over time.

Most battles are won in the preparation stage, not on the battlefield. If you don’t understand the nature of the risks, when they do show up, it’s far less likely you’ll be able to keep your head while others are losing theirs. Your well-developed plan could well end up in the trash heap of emotions. Forewarned is forearmed.

Later this week we’ll take a look at the two premiums related to bonds—term and default.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.