27 February 2023 – Here at Human Financial we’re always asking ourselves, “Which is the best asset mix to achieve our investment outcomes?”
As legendary investor Warren Buffet says, "Price is what you pay, value is what you get." But comparing the value of different assets can be a complicated business.
We use a variety of methodologies, but the simplest way to compare apples and oranges is to look at the income they generate. This approach isn’t perfect, as it ignores other characteristics such as volatility and liquidity risks; however, it does provide a reference point of relative valuation. It’s also the way most people compare different investments or assets in their everyday life: what yield can I get?
Equity Risk Premium
To compare equities and government bonds, for example, a commonly used metric is the equity risk premium (ERP), which provides a single measure that compares the relative attractiveness of equities to government bonds across time. The formula is:
Figure 1 shows the ERP for the S&P 500. ERP is regime dependent, i.e., it is not static, and its movements are driven by macro-economic factors. Having said that, it’s clear that US equities are currently at their most expensive levels since before the GFC. Despite the selloff in 2022, buying riskier equity assets currently yields you less than 2% more than the safe-haven asset of US treasuries.
This relative unattractiveness of equities is partly due to US 10y treasuries yielding close to 4%. Although this yield isn’t particularly appealing historically speaking, it’s at a level that investors could only have dreamt of during the last 15-odd years.
While our investment process doesn’t hinge on a single metric, the ERP does clearly highlight the need for caution within investment portfolios. Even after a poor performance in 2022 there may be more trouble for equities ahead.
