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Re: [sharechat] Equity risk premium

From: "" <>
Date: Sun, 30 May 2004 15:20:59 +1200

Hi winner69,
>One could say that as equities have outperformed bonds 
>over the long term then equities are actually less 'risky'
> than government stock -
>and that there is no need for an equity risk premium. 

That is my position.

>The only counter to this argument is that equity investors 
> can actually lose their capital 
>but income streams and capital from 
>government stock are generally guaranteed. 

Income streams from government bonds are guaranteed -  yes.
Capital guaranteed?    Only if you hold the bond from the day it is 
issued by the government to the day it is cashed up by the 
government.  If you try to cash it up, or buy it,  'in between' the capital 
value of the bond will be affected by the prevailing interest rates at the 
time you trade verses the coupon rate at which the bond was issued at.   
Depending on prevailing interest rates your government bond could be 
worth more or less than face value.    So the capital value of a 
government bond can change, albeit not by as much as a share might 
expected to fluctuate in value.

>Therefore equities are actually 'riskier' than government 
>stock and there is a need for a equity risk premium to
>compensate investors for that risk.

So the commentators keep telling us.    But isn't the risk that a share 
might drop in value to as large extent mitigated by the fact that it might 
gain in value?   I guess the commentators keep telling us we need to 
seek an equity risk premium, so that means the answer must be no.   
Yet, long term shares have irrefutably outperformed bonds.  So what 
gives?    The only way I can see out of this conundrum is that the 
'equity risk' we keep hearing about is either 'short term risk' or 'specific 
company risk' or both.

In the short term, there is a significant chance that any share you buy 
will underperform fixed interest.     That is undoubtedly true.  However, 
if that is the meaning of 'equity risk' it has an interesting corollary for 
long term diversified equity investors.  The longer your investment 
horizon and the more shares you have in your portfolio, the less equity 
risk matters.  Or, taking the extreme view, long term diversified 
investors should ignore equity risk!


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