Eric Falkenstein

From Super Safe to SafeNot from Safe to Insanely RiskyReturn Discount for CashNo alpha possible

Moody’s data back to 1919

Return assuming 10 year bondsCan’t arbitrage: Can’t borrow at AAA rateBut, makes ‘sense’ in standard theory (if too

much)

Baa Aaa Diff

Avg. Yield 7.12% 5.92% 1.14%

Avg. Ann Return 7.09% 5.95% 1.15%

3mo 1yr 3yr 5yr 10yr 20yr 30yr

AnnRet 4.99 5.66 6.08 6.27 6.37 6.31 6.45

AnnStdev 5.10 5.66 6.06 6.26 6.48 6.65 7.29

The most important constant in finance

i f i m fEr r E r r

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m fE r r

Mehra and Prescott (1986): 6.2%1999 Barclays and CSFB estimated 8.8%Ibbotson (1926-97): 8.9%Finance Texts (1998): 8.5%Ivo Welch Survey (1998): 8.5%Crash!AIMR estimate (2002): 3.0%WSJ survey (2005): 2.0%CFO Magazine (2005): 5%Ivo Welch (2009): 2%-4% at most 1%-8%

Initial used T-bills instead of T-bondsArithmetic vs. Geometric averages

Net cost of Vegas?Beardstown Ladies investment club1983-94 return 23.4%Best selling authorsAudited financials: 9.1%, below 14.9% for

marketFailed to include contributions

1 to 2 to 1 has a total return of 0%100%, -50% return has average of -25%Arithmetic returns useful if you rebalance, as

opposed to invest all your money at inceptionStock returns have volatility around 20%, for

the indices, which implied a 2%

2

2G Ar r

US Dividend yield went from 7.43% in 1872-1950, to 2.55% from 1951 to 2000

Fama-French (2002): about 4% of Post WW2 return from this effect

Ret=div+cap gainIf div rate goes down, one time cap gain

Dichev (2005)1, 2, 1

return 0% if cf is {-1,0,+1} return -17.7% if cf is {-1,-1,+1.5}

Total return different than Internal Rate of Return based on timing of investments

Distributions Dividends-New MoneyCorr(Distributionst,Returnt+1)= +33%

Corr(Distributionst+1,Returnt)= -27% bad timing

1.3% premium for buy-and-hold and IRR for NYSE/AMEX 1926-2002

5.3% for Nasdaq 1973-20021.5% for 19 major international stock exchanges

1973-2004

Commissions, 8.5% load through 1970’s to buy a mutual fund

bid-ask crossStocks quoted at 8 ¾ - 9 in the 1990sbuy at 9, sell at 8 ¾, lose 2.78%Phantom cost: most investors don’t know real

time pricesStoll and Whaley (1983) 1.78% comm+bid-askBhardwaj and Brooks (1992): 4.4% totalCurrently very low if you are smart (0.2%)

No good data, proprietaryI have data from a dead Hedge Fund, so its

not proprietary (ie, Deephaven)Look at fill price, vs price at openGenerally, 0.2% using sophisticated

algorithms on liquid stocks when putting on $100k

Around 1-5% when putting on 1-10% of Avg. Daily Volume

USA primary data point in World Value Weighted Index

Coincidentally, 2-0 in World WarsCommunist Party not popular

Brown, Goetzmann, and Ross (1995)Czechoslovakia, Hungary, Poland, Russia, and

China all zeroed outJorion and Goetzmann (1999)

US real return 350 basis points above median for 39 countries in 20th century

Peso-Dollar FX rate fixed from 1954-76Higher interest rate in PesoPeso ‘floated’ in 1976: lost 45%Peso devalued by 82% in 1982Small probability, big loss, explains interest

rate premiumRobert Barro (2006) argues a correct

probability of a significant catastrophe explains much of the equity premium, about 300 basis points2% change of a 15% to 45% GDP decline

10% stock return: 6% post tax with a 40% tax rateGannon and Blum (2006) apply this to S&P500

assuming 20% turnover from 1961-2005, using actual capital gains, dividend top-tier tax rates

Cap gain avg: 26%Top tax rate avg; 49% (includes 6% state tax)

Total after tax equity return 6.72%, vs. 10.62% pre tax

Long Term Municipal Bond Buyer Index return: 6.14%

Geometric vs. Arithmetic Averaging 2.0% Survivorship Bias 3.0% Peso Problems 3.0% Post WW2 Reduct. in Eq. Premium 3.0% Taxes 2.0% Adverse Market Timing 2.0% Transaction Costs 2.0% Sum 17.0%

Most estimates around 3.5% for equity premium. With these additions, the Marginal Investor clearly could be seeing a 0% equity premium.

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Risk premium exists in really low risk areas likeAAA-BBB spreadShort end of yield curve

Equity Risk Premium a mirageReasonable costs take it to zero for your

average investorWhy is finance so remunerative? Selling

dreams about getting rich, misdirection.When alpha is possible, people are

benchmarking, and selling hope