You only get one chance to make a first impression, and I wonder whether I blew my chance with the readership of Penny Sleuth by writing about an exceptionally boring-sounding bit of financial jargon last week – “the equity risk premium”.
I had to do it! It might sound boring, but it’s about the most important idea in all of investing.
Today I’m digging back into the equity risk premium. Last week I called it “a godsend for ordinary investors”. Today I’m going to explain what I meant by that, and why you’d be stone mad not to take advantage of it.
Here’s what I said about it then:
The equity risk premium is a dead simple idea. It just means that stocks pay more than safer assets like bonds in the long run. The reason for this is that stocks are riskier than bonds – in other words, there’s a bigger chance that you might lose your money if you invest in them.
I want to expand on that last part a bit.
The reason stocks are risky is that their value bounces up and down a lot more than the value of safer investments like bonds, or money in the bank.
So, even though stocks go up a lot faster than money in the bank, they’re considered more risky because there’s a bigger chance their value will fall in the short term.
If you need to “cash out” soon, and sell your investments, having all your money in stocks might be a bad idea. That’s the “risk” part of the equity risk premium. It’s what the market is compensating you for.
Here’s what the equity risk premium looks like on a chart. Risk is shown by the downward “zags” in the red line below. The premium is the way that the red line goes up far faster than the blue line.
The premium is the extra return that stock market investors get, relative to safe investments. And it’s absolutely massive.
In fact, in the UK since 1900, investors in stocks have made 53 times more money than investors in bonds. That’s the equity risk premium in action.
The evidence is just unbelievably clear. If you want to make a lot more money, investing in stocks is the only game in town.
Imagine opening a savings account at the bank. When you shop around for different savings accounts, you’ll see that you can get a better interest rate (return) if you’re willing to invest your money for a longer period of time.
Investing in stocks – if you do it properly – should make you a great return. But to take full advantage of it, it makes sense to invest your money for longer periods of time. That gives the “premium” time to work its magic, and cancel out the risk that your stocks might fall in the short run.
The story doesn’t end here. It turns out that the equity risk premium can itself be amplified by investing in certain specific types of stocks. More on that soon.
A lot of important-sounding investment ideas get thrown around in the media. But I reckon this is as important as they come. If you wrap your head around it, and use it properly, it’ll make you far richer. What could be more important than that.