The worse the world gets, the better housing will: Christopher Joye

In the standard literature, the so-called “equity risk premium puzzle” refers to the substantial outperformance of listed shares over safer government bonds. The magnitude of the differential in returns generated by these assets suggested to some that investors were inconceivably cautious, or risk-averse, and thus demanded exceptionally high returns from equities in order to compensate them for the market’s sizeable volatility, or risk of loss. 

There are at least three other explanations that I am more sympathetic to. The first is that there is, in fact, only a small – indeed, far too small – equity risk premium over government bonds when you run the right numbers. I will return to that later. 

The second (related) argument is that investors’ portfolios have actually been plagued by quite irrational and poorly compensated “risk-seeking” asset allocations, which have underestimated the probability of loss in, and relative valuations of, shares compared with far more secure fixed-income assets like cash and government bonds. 

I suspect that this irrationality was itself influenced by investor ignorance about corporate capital structure risk and, more fundamentally, the important differences between debt and equity. I have little doubt that these misconceptions continue to prevail at the retail punter level. I would venture they also exist amongst more sophisticated institutional investors. 

One concern is that this equities’ “obsessive-compulsive disorder”, as I like to call it, appears to be a peculiarly Australian affair, which is most endemic in our superannuation system. It is an interesting sociological question as to whether this is somehow linked to our unusually pervasive gambling culture. 

According to the OECD, Australian super funds have far and away the highest exposures to listed equities of the 31 countries they survey (see first chart below). This has manifest in inferior performance vis-à-vis other pension systems around the world. Click to enlarge

Here the OECD finds that over the last three years,“the worst [pension] performance was observed in Spain (-2.0% nominal, -3.8% real), Australia (-2.8% nominal, -5.6% real), Portugal (-3.1% nominal, -4.1% real), and Estonia (-3.7% nominal, -7.7% real). The average, yearly net return over the period [for all 31 countries] was 5.4% in nominal terms and -0% in real terms [ie, dramatically higher than Australia’s results] 

As I have explained before, debt ranks ahead of equity, commits to repay you the dollar value of your original investment, and promises a predetermined rate of return. 

Equity does not offer you a guarantee to return your capital, is subordinate to debt in the event of insolvency (i.e., you get paid last), and directly exposes you to the risk of loss in concert with the prospect of non-specified gains. 

One of the great ironies of the asset-allocation puzzle that has led to excessively high weights to shares in Australian portfolios is, as I explained here, that debt is, by its construction, far easier for punters to understand, analyse and value than equity. 

The lay observer would not, however, think this given the vast industry complex that has been built up around promoting the share market –with countless online retail stockbrokers and media backers – that in turn make investing in shares seem like it need no more qualification than a functional index finger. 

But as any professional analyst understands, the highly uncertain assumptions and complex discounted earnings models required to estimate the equity returns that may or may not materialise from a listed company are orders of magnitude more sophisticated than valuing a floating-rate debt security.