Posted by: Dirk | March 4, 2008

Bonds or equities in the long run?

The above question was posed in this week’s Economist:

Mr Edwards argues that investors have been lulled into a false sense of security that equities are cheap. They may look cheap relative to government bonds, but that measure is irrelevant. They may look cheap in terms of prospective profits, but profits expectations are inflated. Compare share prices with a 10-year average and equities look as expensive as they did before the 1929 crash. Factor in the possibility of a severe recession, rather than the mild one most economists are expecting, and investors could be in for a nasty shock.

This argument is refuted by Brad DeLong and Konstantin Margin. The authors look at the U.S. Equity Return Premium. They claim that, although the puzzling premium for holding equities in the long run – compared to bonds – is not clearly understood, there are no signs that this puzzle will not hold in the future. Hence the conclusion:

These considerations suggest a strong case for revisiting issues of financial institution design, in order to give the market a push toward being more willing to invest in equities. Economists need to think about institutions that would make long-run buy-and-hold bets on equities easier and more widespread. Mandatory personal retirement or savings accounts with default investments in equity index funds? Automatical investment of tax refunds into diversified equity funds via personal savings accounts? Investing the Social Security trust fund balance in equities as well?


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