Friday, February 10, 2006

The Stock Market and the Equity Risk Premium

Investing in the stock market has always appeared risky to me, although I admit it's a gut reaction. Bonds scare me too, although less so, for reasons which I can't explain, having never owned any.

The fact that "a lot of bright economists" can't find a reason for a higher risk premium for equities than for bonds doesn't surprise me, but Peter Swan's recent idea seems to describe my own feelings pretty precisely.


[Thanks to montanagspc.org for the photo.]

He says:

""While financial economists are used to thinking of equity markets as being highly liquid, they are in fact highly illiquid relative to government securities such as bonds and Treasury bills," he says. "In the US over the 21-year period, 1980-2000 the average turnover rate for US government bonds and Treasury bills was 13.9 times per annum compared with 0.575 times per annum for equity on the New York Stock Exchange, a relative rate of 24.58 times ... My basic idea is that the equity premium is no more than compensation to equity holders for this greater illiquidity." (Quoted in The Australian by Alan Wood, here.)

This jives with my gut feeling -- a scientifically insignificant finding, perhaps, but a crucial one as concerns my own behavior.

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