Edgar Lawrence Smith: the equity (risk) premium

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The history of modern day asset management arguably begins with the finding that bonds are actually not the only way to invest.

Equities, previously considered to be purely speculative investment instruments, were elevated to the status of an asset class in their own right when Edgar Lawrence Smith published his ground-breaking book ‘Common stocks as long term investments’ in 1924.

As a result, the concept of the ‘equity risk premium’ (also referred to simply as the equity premium) came into being.

Exhibit 1: A ground-breaking book – ‘Common stocks as long term investments’ by Edgar Lawrence Smith

Source: Google Books, BNP Paribas Asset Management, as of 29/09/2017

Edgar Lawrence Smith (1882-1971) was an investment manager in the finance industry. After receiving a Bachelor of Arts from the University of Harvard in 1905, he worked in banking and later became a financial advisor to the Low, Dixon & Co. brokerage firm. While there, he recounted that in his Harvard class’s 50th reunion yearbook he had tried to write a pamphlet on why bonds were the best form of long-term investment. Supporting evidence of this could not be found.

This discovery led to the publication in 1924 of Smith’s revolutionary book ‘Common Stocks as Long Term Investments’ which showed that over time, stocks were a better form of long-term investment than bonds, yielding a better return despite their higher risk. The New York Times described Smith’s book as the work that “laid down the principle which so reverses the accepted estimate of the relative investment value of bonds and common stocks as to have aroused the keen interest of Wall Street and investment bankers in general.”

The success of his book was reckoned to be a pivotal intellectual influence behind the stock-market boom of the 1920s. Riding on the back of his literary success Smith launched a mutual fund firm: Investment Managers Company, which he subsequently – and, it has to be said, ironically – lost in the 1929 stock-market crash. He spent his final years researching, writing and painting. Later studies of the comparative long-term performance of equities and bonds by Alfred Cowles (1939), Roger G. Ibbotson and Rex Sinquefield (1976) endorsed the conclusions of Smith’s 1924 study.

The concept of the ‘equity risk premium’ is now of course widely accepted. And, with bond yields as low as they currently are, it is arguably more apposite than ever.

Exhibit 2: Arithmetic average of the year-by-year difference between the annual return (in %) of stocks and that of Treasury bills and the difference with 10-year Treasury bonds; the periods covered are since 1928, over the last 50 years and over the last 10 years (data up to Jan 2017)

equity

Note: the T-bill rate is a three-month interest rate. The return of the constant maturity 10-year T-bond includes coupon and price appreciation.

Source: Stern, NYU, as of 29/09/2017

Exhibit 3: Geometric average of the year-by-year difference between the annual return (in %) of stocks and that of Treasury bills and the difference with 10-year Treasury bonds; the periods covered are since 1928, over the last 50 years and over the last 10 years (data up to Jan 2017).

equity

Note: the T-bill rate is a three-month interest rate. The return of the constant maturity 10-year T-bond includes coupon and price appreciation.

Source: Stern, NYU, as of 29/09/2017


Written on 29/09/2017

As head of Global Quantitative Management, Etienne Vincent writes about topics including smart beta (investment strategies that use non-traditional indices that are not based on market capitalisation), factor investing (investing in securities based on characteristics associated with higher returns), absolute return, quantitative (investment management; i.e. using mathematical measurements and calculations to understand or predict behaviour or events) and the equity risk premium (the phenomenon that stocks offer a higher return despite their higher risk).

Etienne Vincent

Head of Global Quantitative Management, THEAM

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