Eric Falkenstein
 From Super Safe to Safe
 Not from Safe to Insanely Risky
 Return Discount for Cash
 No alpha possible
 Moody’s data back to 1919
Baa
Aaa
Diff
Avg. Yield
7.12%
5.92%
1.14%
Avg. Ann Return
7.09%
5.95%
1.15%
 Return assuming 10 year bonds
 Can’t arbitrage: Can’t borrow at AAA rate
 But, makes ‘sense’ in standard theory (if too much)
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
Eri  rf  E i  rm  rf
E  rm  rf


 The most important constant in finance
7
 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-bonds
 Arithmetic vs. Geometric averages
 Net cost of Vegas?
 Beardstown Ladies investment club
 1983-94 return 23.4%
 Best selling authors
 Audited financials: 9.1%, below 14.9% for market
 Failed 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 inception
 Stock returns have volatility around 20%, for the
indices, which implied a 2%
rG  rA 

2
2
 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 gain
 If 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 Money
 Corr(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 1973-2002
 1.5% for 19 major international stock exchanges 1973-2004
 Commissions,
 8.5% load through 1970’s to buy a mutual fund
 bid-ask cross
 Stocks quoted at 8 ¾ - 9 in the 1990s
 buy at 9, sell at 8 ¾, lose 2.78%
 Phantom cost: most investors don’t know real time
prices
 Stoll and Whaley (1983) 1.78% comm+bid-ask
 Bhardwaj and Brooks (1992): 4.4% total
 Currently very low if you are smart (0.2%)
 No good data, proprietary
 I have data from a dead Hedge Fund, so its not
proprietary (ie, Deephaven)
 Look at fill price, vs price at open
 Generally, 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 Wars
 Communist Party not popular
 Brown, Goetzmann, and Ross (1995)
 Czechoslovakia, Hungary, Poland, Russia, and China all
zeroed out
 Jorion and Goetzmann (1999)
 US real return 350 basis points above median for 39
countries in 20th century
 Peso-Dollar FX rate fixed from 1954-76
 Higher interest rate in Peso
 Peso ‘floated’ in 1976: lost 45%
 Peso devalued by 82% in 1982
 Small probability, big loss, explains interest rate
premium
 Robert Barro (2006) argues a correct probability of a
significant catastrophe explains much of the equity
premium, about 300 basis points
 2% change of a 15% to 45% GDP decline
 10% stock return: 6% post tax with a 40% tax rate
 Gannon 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
 Survivorship Bias
 Peso Problems
 Post WW2 Reduct. in Eq. Premium
 Taxes
 Adverse Market Timing
 Transaction Costs
 Sum
2.0%
3.0%
3.0%
3.0%
2.0%
2.0%
2.0%
17.0%
 Most estimates around 3.5% for equity premium.
With these additions, the Marginal Investor clearly
could be seeing a 0% equity premium.
20
 Risk premium exists in really low risk areas like
 AAA-BBB spread
 Short end of yield curve
 Equity Risk Premium a mirage
 Reasonable costs take it to zero for your average investor
 Why is finance so remunerative? Selling dreams about
getting rich, misdirection.
 When alpha is possible, people are benchmarking, and
selling hope