Two financial things for a Friday

Here's two things that I have been thinking about recently.

1. Equity Risk Premium

2. There has been a lot written lately about the anticipated low equity returns coming over the next few years. Ballooning valuations have been driving down forward-looking valuations. See ERN, Bogle, Seeking Alpha, … etc.

But what does this mean? Well, if you need a real return of 4% in the future and stocks might only be expected to have a 6% nominal return, and inflation say 2%,  then you are in trouble if you have anything less than 100% equities.

In pondering how low equity assumptions can go I like to give a nod to the equity risk premium (ERP). This is the (imaginary) premium that investors require to take on the risk of investing in equities, and is expressed as the difference between the return on stocks less the return on bonds. This difference is the ERP. Historically it has been running at about 3-4%.

The reasoning for the ERP is that  you start with a baseline investment return of the risk free return you can achieve with Treasury investments. If you are rational you would only take more risk if you expected to generate more return. Since equities are pretty volatile then you would expect additional return over bonds to keep you in the casino.

Given that the 10 year Treasury has been hovering around 2.5% and the 30 year Treasury around 3%, and if we assume an ERP of 3-4% then we might arrive at equity returns of around 5.5%-7%. So I would say anything in this range seems pretty sensible.

2. Capital exhaustion

It seems that almost all those pursuing financial independence are looking to generate a passive return from their fixed capital and not run that capital down if at all possible. I can see why – it's scary to run out of money late in life! There is a common argument – "oh well, I can just leave a nice lump sum to my heirs or charity". That is laudable, but really just smacks of financial sloppiness. But more than that it is quite possible that people are saving up unnecessarily large lump sums.

For example if you want to meet payments of $40,000 per year for perpetuity with a 4% investment return you need $1,000,000 in the bank. Now assume that you want to meet the same $40,000 payments, and the investment return is the same at 4%, but now you only need your reserve to last 50 years. What do you think the capital sum required would be? It's $860k. It's 14% less.

That means you could potentially have retired a lot earlier, or you could have lived on more money.

Ok – I get it. There are risks. Longevity, investment returns, sequencing risks etc etc. You need a cushion. But do you really need to jump from 50 years to perpetuity? That's a big jump.

Anyway – do you want to hear more about these topics? I certainly want to write a full blog post on that last item. Comment below – thanks!