Why Stock Investors Get Paid

Yesterday, into the teeth of the decline, I put this out:

Stocks earn an equity risk premium above risk-free bonds of around 3 percent on an average annual basis. Do you know why? Today is why.

— Downtown Josh Brown (@ReformedBroker) October 15, 2014

It’s a concept that pros understand but that many individual investors have not been taught.

Nick Murray counsels us to be owners, not lenders, in terms of the way we invest.

Bond investors, the lenders in this example, only ever get principal back and their interest payments – and over long stretches of time their after-tax, after-inflation profits from this activity are nowhere near what they could be had they owned equity.

Owners (equity investors) on the other hand, have a share in the future productivity of the enterprise – a much greater potential payout over time than bond interest and the return of their original capital – but they endure greater risk in order to earn this (the No Free Lunch principle).

This is not to say that bonds have no use or that equities will always do better. But it is a good way of understanding the tradeoffs we make when there is a long horizon ahead of us and we’re trying to maximize the potential of our investment dollars.

Sometimes, you’re getting a free ride as an owner – 2013 was a great example of that. But on days like yesterday, you had to earn your equity risk premium. You had to grit your teeth and watch some 400 points get ripped out of the Dow Jones in the blink of an eye.

In life, earning stuff is sometimes preferable to having everything handed to you. It feels better on the other side of whatever ordeal you’ve gone through and it builds character. Pat yourself on the back for not panicking.

This is why stock investors get paid.