While many academics and practitioners expect the future equity risk premium to be lower, they also expect the bond risk premium to be higher. Going into great detail to defend this expectation is unnecessary. With TIPs currently yielding more than the 1%-2% real return reflected in the traditional AS, there can be little question that our assumptions need revisiting.

If one concludes that the equity risk premium remains stable and the bond premium increases, allocations will shift in favor of bonds. The risk of such a shift is that the stock premium might actually decrease and a shift to bonds will prove counterproductive.

If the conclusion is that the stock premium will decrease and the bond premium increase, we can no longer say with assurance that "stocks will outperform bonds in the long-term." We will also have to revisit the reality of our clients' ability to achieve goals previously believed to be obtainable.


Practitioners need to consider and plan for the impact of the changes in risk premium. I believe that, until recently, I've personally succumbed to wishful thinking. In addition, we must consider investor heuristics. On one hand, a reduced stock return would suggest an increase in the stock allocation. On the other hand, the uncertainty of stocks' long-term superiority vis-a-vis bonds will multiply a loss-averse client's discomfort with an increased stock allocation. Our quandary is further compounded by another behavioral response noted by Rosenberg. Namely, "Investors have forgotten the meaning of risk: They tend to believe that risk guarantees reward: under that interpretation, risk is not risky."

Regarding investment issues, I've revisited my position relative to risk premium and tentatively concluded that the bond premium has increased to 3%-4% and that the stock premium has probably decreased by an unknown amount. I also agree with the conclusions of Professors Chan, Karceski and Lakonishok that recent stock price performance is neither a result of real asset pricing or a new paradigm economy. The explanation is behavioral.

Regarding behavioral considerations, I believe that my clients look to me to use my professional skills and knowledge to assist them in achieving their personal goals, including my ability to balance the expectations for an uncertain future with an understanding of my clients' psychological, emotional and behavioral attributes. They want to know such things as:

How much can I spend?

How much should I save?

How long should I work? How realistic are my retirement plans?

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