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 Return assuming 10 year bonds Can’t arbitrage: Can’t borrow at AAA rate But, makes ‘sense’ in standard theory (if too much) BaaAaaDiff Avg. Yield7.12%5.92%1.14% Avg. Ann Return7.09%5.95%1.15%

3mo1yr3yr5yr10yr20yr30yr AnnRet AnnStdev

The most important constant in finance 7

Mehra and Prescott (1986): 6.2% 1999 Barclays and CSFB estimated 8.8% Ibbotson ( ): 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 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%

US Dividend yield went from 7.43% in , 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(Distributions t,Return t+1 )= +33% Corr(Distributions t+1,Return t )= -27%  bad timing

1.3% premium for buy-and-hold and IRR for NYSE/AMEX % for Nasdaq % for 19 major international stock exchanges

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 20 th century

Peso-Dollar FX rate fixed from 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 , 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 % pre tax Long Term Municipal Bond Buyer Index return: 6.14%

Geometric vs. Arithmetic Averaging 2.0% Survivorship Bias3.0% 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. 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