For my August Project Syndicate column...
Past performance paragraph needs work.
Firstly, what exactly is Shiller's diversified stock portfolio. It certainly seems to have a lot more growth in the early years than say the S&P500, so is that growth due to high dividend payouts? The 1929 crash is hardly noticeable in his portfolio, yet huge in index prices. [Should those stockbrokers not have jumped?]
If your portfolio had stocks that went bankrupt or were merged in the year of holding, how do you buy them to rebalance the portfolio? A merger has already extracted that value for the "winners". An index just replaces that stock with a new "up and comer".
We do know that stocks are riskier than treasuries, and that junk bonds are riskier than treasuries. What exactly is the acceptable risk premium? Is it just a judgement of the participants, or some sort of pareto value for the slope of the risk premium?
Not everyone has the same investment goals. Pension funds need as much predictability as possible, so bonds are the preferred vehicle. That reduces bond returns if there is competition for the bonds. Historically defined pension plans were a major buyer of such investments. That has changed since those plans have largely disappeared except for government employees.
Bottom line is that I am not confident that the claimed "excess risk premium" is real and may be an artifact of index construction and other factors. Shiller is in effect claiming the market is inefficient. I don't believe it. If it was, there would be a lot more equity investors making out like bandits on the quiet.
I'm not sure of what the puzzle is. If you think of the asset price as an estimate of the potential cash flow value, buying bonds gets you fixed cash flow, but buying shares gets you a cash flow tied to overall growth in the economy.
Suppose you have a sum of money. If you lend the money to a large portfolio of business ventures, your cash flow will be some fraction, discounting for failures, of expected interest plus the return of your capital. If you use the money to buy shares of a large portfolio of business ventures, your cash flow has no upside limit. individual businesses may fail, but future cash flow will reflect overall economic growth. An interest and return of principal stream is limited no matter how much an economy grows unlike fractional ownership.
The risk in buying a portfolio of shares is that the economy will fail to grow. This risk, however, applies to both shares and bonds. Borrowers are less likely to repay when the economy is stagnant or collapsing.
P.S. Suppose Becky Sharp has somehow have gotten her mitts on 100,000 pounds. Let's not discuss how she did this. That's Thackeray's job, and he was good at it. Becky would have been sore tempted to buy consuls paying 3% and be done with it, but a more sophisticated and avaricious Becky might have considered buying a broad portfolio of shares instead. I'm sure Thackeray would have had his Becky go for the consuls and, by machinations, lose her fortune ignominiously. The shares option would have gotten us a very different novel, something more of the impoverished slime mold to mistress of the universe genre so popular in the 1980s.
Is it a puzzle or selection bias?
When it comes to the present day, if you don't like Ole Peters answer to the "equity premium puzzle", then I have nothing to say.
When it comes to the *past*, though, things are a little different. Between 1750 and 1900, annualized inflation in the UK was 0.39%; a pound in 1750 was worth about 1.8 pounds in 1900. (https://www.officialdata.org/uk/inflation/1750?endYear=1900&amount=10) This average concealed violent episodes not only of *inflation*, but also of *deflation*. That is to say, where bonds were subject to "wealth destroying inflation", equities were subject to wealth-destroying deflation.
"There is this a very strong sense in which it is much harder to raise money on the stock market then it should be, and that American business is hobbled thereby."
If uncertain losses do indeed loom larger than gains (Prospects Theory; thanks, Kahneman, Tversky and Thaler), keeping enough people from bidding on stocks, then it is astounding that a psychological issue -- to which humans may be hardwired -- has had such a large economic consequence. (I'm not sure I got this right; please correct me).
Retired index fund manager here…
The current notion of being “fully diversified” is to hold every asset in the same percentage as the market. If Apple Inc's market value is 5% of the total market value of US stocks, it should be 5% of a well-diversified portfolio.
When Apple's share price drops, so, too, does its market value. Say it goes to 4%; it automagically drops to 4% of my portfolio. As long as I held it at the market weight to begin with. Likewise if it zooms, its share of my portfolio rises proportionately
An index portfolio only buys and sells to reflect NEW stocks entering the market. Got some dividends? Spend them on the *identical* mix that you already own. Want to spend down your portfolio by say, 10%? Sell 10% of each position. Stocks that die, eg WeWork or SmileDirect? Your friend Mr. Market sold the value for you; all you need to do is delete the entry from your database.
There are some minor intricacies like mergers, buyouts, share repurchases or secondary offerings etc. They are all very small. Almost all BUYS and SELLS are to deal w cash moving in or out of the portfolio and your broker looking for commissions will go hungry