In the last few weeks, stock prices corrected by as much as 12.5%. As of today’s close, stock prices are about 5% lower than the January 3rd all-time high. A correction in stock prices may still be under way, as Russia threatens the modern world’s geopolitical framework by invading Ukraine, and the U.S. Federal Reserve just began tightening credit to extinguish the worst inflation flareup in 40 years, while the Covid-19 pandemic threat to public health and the worldwide economy lingers.
Which makes this the perfect time to review the equity risk premium: how much investors have been rewarded for taking the extra risk of investing in stocks instead of rolling over 90-day Treasury Bills, which are said to be “risk-free.”
Stocks, as measured by the Standard & Poor’s 500, in the 20 years ended December 31, 2021, averaged a +9.5% annual return, nearly seven times the +1.2% annual return on the risk-free 90-day U.S Treasury Bill. Backed by the full faith and credit of the U.S. Government, T-Bills are considered a riskless investment, while the value of stocks is subject to ups and downs and, in theory, your entire investment could be lost in stocks.
Subtracting the return on T Bills from the return on stocks, the resulting 8.3% is the premium paid for taking the risk of owning U.S. stocks over the 20-years. To be clear, investing in America’s 500 largest publicly-held companies earned an average of 8.3% more annually than a risk-free investment in the past 20 years.
This 20-year period encompassed three frightening bear markets -- the tech crash of 2002, the financial crisis of 2008, and the Covid downturn of early 2020. Past performance is no guarantee of your future results and that, paradoxically, is precisely why investors are paid a premium for owning stocks.
Yes, stocks are risky and past performance is no guarantee of your future results! That is precisely why stocks have returned 8.3% more annually than U.S.-Government-guaranteed investments through three bear markets and financial crises of the 20 years ended December 31, 2021.
The Standard & Poor’s 500 stock index closed this Friday at 4,543.06. The index gained +0.51% from Thursday and +1.77% this past week. The S&P 500 is up +68% from the March 23, 2020, bear market low.
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