We always adjust for risk

  • Using two distributions, one for equities and one for bonds, we can calculate the simple probability of equities beating bonds.
  • But we also need to be paid for the extra risk of investing in equities – often called the equity risk premium.
  • This acts as a hurdle rate and automatically reduces the probability of equities beating bonds.
  • There are many way of estimating the equity risk premium. Some are based the long run forecast returns of equities and bonds. Others use the historic excess returns of equities relative to bonds.
  • We use a very simple identity. Extra risk means extra risk, in other words excess volatility – the volatility of equities minus the volatility of bonds.
  •  This number will vary depending on market conditions, but that’s the whole point. Change in risk appetite is one of the main drivers of equity and bond performance.