A conversation with Professor Rajnish Mehra (holding the Deutsche Bank Chair at the Luxembourg School of Finance) on the return on investment

Make out like a bandit

d'Lëtzebuerger Land du 28.11.2014

d'Land: In 1985 you published The Equity Premium: A Puzzle together with the future Nobel Prize winner, Edward C. Prescott. To this day, it remains one of the most quoted articles in economics because it shows that over the last hundred years the return on stocks has been significantly higher than the return on government bonds. Much larger than predicted by the standard model of financial economics.

Rajnish Mehra: A lot has happened over the last century. We have seen two World Wars, hyperinflation, deflation, depressions and financial crises, yet equity has done exceedingly well over this period. The real return (adjusted for inflation) on equity has been 7,7 per cent on average. This is hard data that I am talking about. If you had held a diversified portfolio of stocks, you would have earned a premium of 6,6 per cent over government bonds in spite of inflation or deflation. That is, if you were willing to hold onto it for a long time.

But in the long run, won’t we all be dead?

The long and the short-run are notions that depend on how many years you have left to live. If the equity market stumbles tomorrow, for me there might not be enough time to see it recover. But most people who are saving for retirement start in their mid-twenties. My advice to this cohort would be to regularly save a fixed amount, say 200 euros every month, and invest it in a low cost diversified portfolio of stocks.

Everything we know tells us that if the past is any indication of the future, you will be a rich person by the time you retire. When you look at the averages over twenty-year periods, historically, stocks have always outperformed bonds. So if I had given you a choice between a government bond (which was completely risk free and had a two per cent return) and a diversified equity portfolio, the equity portfolio would have been preferable. Even in the worst-case scenario, you wouldn’t have earned less than a two per cent return over the period of a couple of decades.

Does this equity premium resist severe depressions?

Historical data is evidence that it does. Take Germany for instance: if you held bonds during the period of hyperinflation after the First World War, they would have been worthless. I have heard instances where somebody who owed you money dumped it by the bucket load on your doorstep and said: “All my loans are repaid now!” Whereas if you had invested in equity, over the long haul, you would have made out like a bandit: 9,8 per cent over the 1900-2010 period, better than stocks in the US!

For a long time there seemed to be a link between the size of the company and the return on capital, but this relationship no longer seems valid…

From 1927 to 1979, stocks from small companies in the US returned about twenty per cent, while large firms returned around ten per cent. But from 1980 on, this “size premium” began to fade. Between 1980 and 2013, it has only been 1,2 per cent. It even went negative for long periods: -2,8 per cent during the Eighties and -3,4 per cent in the Nineties. If over the last twenty years, you had traded based on the size premium, you would have lost money…

The moral is: if historically, some investment class does well it does not necessarily mean it will continue to do so in the future. The vanishing “size premium” has taught us a valuable lesson. Historical relationships without any economic foundation are no guarantee that these relationships will hold in the future. Some researchers see a relationship and give investment advice based on that. Their observations are a statistical artefact, and may have no predictive power going forward.

Is there any scientific way of predicting what the short term will bring?

The equity premium that we documented in our 1985 paper is only valid for long-term investments. It has little to do with what the premium is going to be over the next couple of years. What we do know is that there exists a negative correlation between the price of equity relative to fundamentals, dividends, for example, and its subsequent return. If the relative price of equity is low, the expected return over the following five to seven years will tend to be high. When the relative price is high, the expected return tends to be low. This negative relationship is not an exact one and it remains noisy. I would not therefore encourage individual investors to “time the market” based on this observation.

The best investment advice that I would give a young person is: Start early. Diversify. Be patient. And another thing: if you are an average investor, high load (fee) funds are not worth the extra diversification they may offer.

Europe is on the verge of deflation. Is there empirical evidence for a link between deflation and depression?

There have been lots of episodes of deflation in the past; other than the Great Depression, research has not found a link between deflation and depression. You have to distinguish between “good deflation”, caused by technological progress, and “bad deflation”, caused by the collapse of demand. Over the last twenty years, the prices of cell phones, airplane tickets, computers and televisions have all come down considerably. Is that a bad thing? No. Essentially we’re all better off at lower prices because of technology. When cell phone prices go down, people buy more of them. The profits of the firms go up, because markets are expanding.

The trouble with deflation arises when the nominal return becomes zero. The nominal return is the real return minus the deflation rate. Since the nominal rate cannot be negative, once the deflation rate exceeds the equilibrium return on capital, it effectively raises the real return on capital and this stifles investment. However, we are not even remotely in a region where we’ll run into this kind of problem. Can deflation be a problem? Yes. Is it likely to become a problem? I don’t think so. There remains an important buffer zone: the real rate of return of the economy.

So the question that deflation raises is: Which investments will still be profitable?

Let’s say the deflation rate is at one per cent and the real rate of return on capital is three per cent. This implies a nominal rate of two per cent, well above the zero lower bound. Investments yielding above three per cent would still be profitable. However, if deflation is running at four per cent, the real return increases to four per cent and businesses will only invest in projects which return at least four per cent. The net result is that projects yielding between three and four per cent will now no longer be undertaken. While moderate deflation will have no effect, severe deflation will stifle investment. The nominal rate will be stuck at zero because why would anybody lend at a negative rate of return? Investors would prefer to just hold on to their money. That is the asymmetry between inflation and deflation. People say deflation is just negative inflation. That is true, but only up to a certain point.

Bernard Thomas
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