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The Meaning of a Slender Risk Premium

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  • Robert D. Arnott

Abstract

The superiority of stocks over bonds for the long-term investor is typically supported by two ideas—a hefty equity risk premium and the growth of dividends vs. nongrowing bond coupons. This piece challenges both ideas. The equity risk premium is unknown. We can estimate it (and all too often, we do so badly by merely extrapolating the past). Should a risk premium exist? Of course. Is its existence written into contract law for any assets we buy? Of course not. This piece develops the outcomes of stock versus bond returns if we accept a skinny risk premium. These “worst reasonable” (5th-percentile-outcome chance of a shortfall) calculations indicate that if the risk premium is 2 percent, wealth from stocks will be 50 percent behind wealth from bonds even after 35 years of patient investing. If dividend growth matches the 4 percent average rate for the 20th century, (1) dividend income (starting from the current 1.5 percent) will need 32 years to overtake bond coupon income and (2) cumulative income from stocks will require a startling 54 years to keep pace with that from bonds.

Suggested Citation

  • Robert D. Arnott, 2004. "The Meaning of a Slender Risk Premium," Financial Analysts Journal, Taylor & Francis Journals, vol. 60(2), pages 6-8, March.
    • Handle: RePEc:taf:ufajxx:v:60:y:2004:i:2:p:6-8
    DOI: 10.2469/faj.v60.n2.2600
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