Of course it isn't random - you can predict it, right?
You had a link that mentioned the book, Triumph of the Optimists. In it, it details the history of stock market returns of 16 countries, which basically represent the Western economies. Since 1900, every single nation has seen equity returns greater than bond returns. That includes Germany, which experienced hyperinflation, a Great Depression, and destruction of the country not once, but twice. It also includes most of the other European countries that were ravaged by war twice which killed tens of millions of people as well as the Great Depression. The United States includes the Great Depression. Schiller goes back to the Civil War, and confirms the same thing, so include that. Most of the economic growth of the world has occurred since 1800, and until recently, most of it occurred in the West. This demonstrates incredible resiliency and dynamic adaptiveness of Western societies and its political and socioeconomic structures. To assume that the future won't be like the past is to assume that there will be some cataclysmic or earth-shattering change in Western societies, one worse than two world wars, hyperinflation, a depression, etc.
Can it happen? Maybe. A declining population is certainly a threat. But the onus is on those to articulate why the future will not be like the past. It's not good enough to say it's random (because it's not) or we might be one day be Zimbabwe or Bangladesh (your "survivorship bias" argument). For those of us who think the future will be like the past, we assume that the culture, laws, institutions, and remarkable adaptability and productivity of our society will not change. You must tell us why these will change.
You ARE excluding those events. You are saying because they would be so detrimental, they should not be included in the analysis. This kind of attitude is part of what lead to the recent housing induced economic crisis. For instance, the sellers of default swaps believed that if it ever got to the point where all those swaps became worth a ton of money to the buyers, the entire economy would be in shambles anyway and nothing would matter.
What I'm saying is that what has ruined economies in the past are calamitous political or economic events, and what has caused significant underperformance by equities is dramatic overvaluation.
Even calamitous economic events of Western societies of the past have not been enough to derail tremendous economic growth over time. Equities are the growth component of the capital structure within the economy. As the economy grows, more and more profits will accrue to equities relative to fixed income.
If there are all these other events that can disrupt our society that would cause stocks to underperform bonds over long periods of time, what are they?
At least for those who are still around? LOL! Classic survivor bias. You've selected the sample that correctly predicted the tech bubble and abandoned the sample of professionals who failed to predict it, lost their jobs, and became shoe salesmen or dentists - and declared that the pros got it right!
Which has nothing to do with your assertion that stocks are only grossly overvalued in retrospect. Those who believe that stocks are only overvalued in retrospect are the guys who lost their jobs.
Actually according to you - over time - stocks are not risky. That would seem to be your entire point. That if I invest over ~30 years, my returns may be lower than someone else who invested in another ~30 years, but I am virtually guaranteed to at least have preserved my capital and make a little bit above Treasuries. If that is indeed what you are saying - that's a LOW risk investment. You can't have it both ways - arguing that stocks pay more over the long haul because they are riskier and at the same time maintaining they're actually not very risky. Which is it?
Completely and totally wrong. I have said it before and I will say it again - stock returns are higher because they are
more risky. They are more risky because they are more volatile and they have the last claim on assets in the capital stack. What I am saying is that because SS is an institution that should last forever - and if it's not, then it won't pay out what it has promised regardless - it should absorb that risk and accrue higher returns over time.
(You may not realize this, but you are making the same argument that diehard free market economists at right-wing think tanks like the American Enterprise Institute were making before the tech bubble collapsed.)
The longer the duration of the institution, the more risk it should take. The shorter the duration, the less risk it should take. If SS is expected to wind down in 5 years, it should be invested almost entirely in bonds. If SS is expected to be around in 150 years, it should have a high risk component. Every pension actuary knows this.
Search for the term "neutral" in the wiki article. You can also use the web. There is plenty of literature on risk neutral pricing (its also referred to as arbitrage free pricing).
I said way back that a basic tenet of economic theory is that there is a trade-off between risk and reward. Every student in finance 101 is taught this. Risk neutrality does not change this. Risk neutrality does not mean that investors don't want to take any risk, nor that they don't want to be compensated for taking risk. It says that prices must be adjusted for risk preferences. "Risk aversion" does not mean people don't want to take on any risk. It means that they over-estimate risk, and need to be paid more to take it on. It means people will take a lower return for a more certain outcome than a higher return with a less certain outcome, even if the expected probabilities are the same.
Actually economic theory cannot adequately explain why equities outperform stocks. Look up "equity premium"
Actually, it does. The equity risk premium states that equities should earn a higher return because equities have greater risk. This is what CAPM is built upon, which derives from modern portfolio theory, which won the Nobel Prize in economics.
The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1990
Actually, yes according to your link.
The equity premium puzzle is a term coined in 1985 by Rajnish Mehra and Edward C. Prescott in their seminal work of the same name, and refers to a lack of consensus among economists on why demand for government bonds - which return much less than stocks - is as high as it is, and even why the demand exists at all. The intuitive notion that stocks are much riskier than bonds is not a sufficient explanation as the magnitude of the disparity between the two returns (the equity risk premium) is so great that it implies an implausibly high level of investor risk aversion that is fundamentally incompatible with other branches of economics, particularly macroeconomics and financial economics. ...
The most basic explanation is that there is no puzzle to explain: that there is no equity premium. ...
Note however that most mainstream economists agree that the evidence shows substantial statistical power.
Economists believe that the equity risk premium is explained by risk, if not the magnitude. One explanation is that using volatility as the sole measure of risk is insufficient to measure all risk. Risk aversion mentioned above may explain this discrepancy.
CAPM doesn't explain WHY the equity premium exists - it only provides a method for pricing securities in a market where the equity premium DOES exist.[/I] You have to plug in your "expected rate of return" from the market to get the formula to work. If you take a look at it,
Capital Asset Pricing Model (CAPM) Definition | Investopedia, you'll see that if the market return = the risk free rate return, the second term on the RHS becomes zero and the LHS becomes equal to the risk free rate. CAPM assumes there is an equity premium - it doesn't explain why there is one.
CAPM is a formula which derives from modern portfolio theory. I included it to demonstrate that theory shows higher risk leads to higher return.
Modern portfolio theory states that there is a trade-off between risk and return. In MPT, the higher the risk, the higher return.
Modern portfolio theory (MPT) is a theory of finance that attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return
Modern portfolio theory - Wikipedia, the free encyclopedia
EDIT - To clarify, economic theory states that an investor must be compensated to take on more risk. Ergo, higher risk, higher return. Higher risk unto itself is why returns are higher for riskier assets.
