The same is true for financial planners and insurance agents selling variable life and annuities. The prospective returns on bonds are easy to calculate -- just look at a yield curve. But if someone prepared a retirement plan based only on bond investing, the amount of savings required would be a lot higher. By assuming returns from equities in excess of that from bonds, less needs to be saved to reach long-term goals. This encourages people to invest in equities -- and helps drive down the future equity premium.
Exaggerated Premiums
The equity premium figures come from looking at time-weighted rates of return. Time-weighted rates of return are typically expressed as the annualized rates of return on an investment where money is put in at the beginning and not taken out until the end. In comparing investment managers, all calculations are done on a time-weighted basis in order to eliminate the comparability problems that arise from cash flowing in and out of different investments at different times.
But ordinary investors don't typically receive time-weighted rates of return, because they don't buy and hold. Instead, they reap dollar-weighted returns, because they trade their investments. Dollar-weighted returns are also called internal rates of return -- they are the constant, annualized rate of return that an investment earned, taking into account the time at which cash flowed in and out of the investment.
Longtime readers of RealMoney are well aware of the effects that fear and greed have on the market, particularly for less experienced investors. The less experienced tend to buy near tops and sell near bottoms. And truth be told, this is true of many institutional investors as well, though probably to a lesser extent. Because of this effect, dollar-weighted returns for retail investors are usually lower than time-weighted returns for equity investments.
Market Commentary A Value Investor's Plan for 2006 1/12/2006 9:58 AM EST This year, I'm going to overweight consumer staples, energy and basic materials, and underweight everything else.
David Merkel 'Just What I Said' Is Just What to Read 11/25/2005 2:00 PM EST Caroline Baum's new collection of past columns holds fresh appeal as a market-myth-busting resource.
Investing Flat Curve Pinches 401(k)s 1/3/2006 4:14 PM EST It may seem esoteric, but the flat yield curve stands to impact 401k plans.
David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At the time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.
Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.
Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.
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