But if you delay the start of this whole process, you gain time in which you can earn above-average returns by e.g. investing into the stock market.
Shouldn’t investing into the stock market be considered a source of average returns, by default? In the long run, the stock market grows at the same rate as GDP.
If you think you have some edge, that might be a reason to pick particular stocks (as I sometimes do) and expect returns above GDP growth.
But generically I don’t think the stock market should be considered a source of above-average returns. Am I missing something?
The stock market should grow faster than GDP in the long run. Three different simple arguments for this:
This falls out of the commonly-used Ramsey model. Specifically, because people discount the future, they will demand that their investments give better return than the general economy.
Corporate earnings should grow at the same rate as GDP, and stock price should grow at the same rate as earnings. But stock investors also earn dividends, so your total return should exceed GDP in the long run. (The reason this works is because in aggregate, investors spend the dividends rather than re-investing them.)
Stock returns are more volatile than economic growth, so they should pay a risk premium even if they don’t have a higher risk-adjusted return.
[Low confidence as I don’t really understand anything about finance.]
It sounds right to me that the stock market can’t grow more quickly than GDP forever. However, it seems like it has been doing so for decades, and that there is no indication that this will stop very soon—say, within 10 years.
(My superficial impression is that this phenomenon it somewhat surprising a priori, but that there isn’t really a consensus for what explains it.)
Therefore, in particular, for the window of time made available by moving spending from now to, say, in 1 year, it seems you can earn returns on the stock market that exceed world economic growth.
If we know that this can’t continue forever, it seems to me this would be more relevant for the part where I say “future longtermists would invest in the stock market rather than engaging in ‘average activities’ that earn average returns”etc.
More precisely, the key question we need to ask about any longtermist investment-like spending opportunity seems to be: After the finite window of above-average growth from that opportunities, will there still be other opportunities that, from a longtermist perspective, have returns that exceed average economic growth? If yes, then it is important whether the distant returns from investment-like longtermist spending end up with longtermists; if no, then it’s not important.
My superficial impression is that this phenomenon it somewhat surprising a priori, but that there isn’t really a consensus for what explains it.
Hmm, my understanding is that the equity premium is the difference between equity returns and bond (treasury bill) returns. Does that tell us about the difference between equity returns and GDP growth?
A priori, would you expect both equities and treasuries to have returns that match GDP growth?
Hmm, my understanding is that the equity premium is the difference between equity returns and bond (treasury bill) returns.
Yes, that’s my understanding as well.
Does that tell us about the difference between equity returns and GDP growth?
I don’t know, my sense is not directly but I could be wrong. I think I was gesturing at this because I took it as evidence that we don’t understand why equities have such high return. (But then it is an additional contingent fact that these returns don’t just exceed bond returns but also GDP growth.)
A priori, would you expect both equities and treasuries to have returns that match GDP growth?
I don’t think I’d expect this, at least not with high confidence—but overall I just feel like I don’t know how to think about this because I understand too little finance and economics. (In particular, it’s plausible to me that there are strong a priori arguments about the relationships between GDP growth, bond returns, and equity returns—I just don’t know what they are.)
I thought about this for another minute, and realized one thing that hadn’t been salient to me previously. (Though quite possibly it was clear to you, as the point is extremely basic. - It also doesn’t directly answer the question about whether we should expect stock returns to exceed GDP growth indefinitely.)
When thinking about whether X can earn returns that exceed economic growth, a key question is what share of those returns is reinvested into X. For example, suppose I now buy stocks that have fantastic returns, but I spend all those returns to buy chocolate. Then those stocks won’t make up an increasing share of my wealth. This would only happen if I used the returns to buy more stocks, and they kept earning higher returns than other stuff I own.
In particular, the simple argument that returns can’t exceed GDP growth forever only follows if returns are reinvested and ‘producing’ more of X doesn’t have too steeply diminishing returns.
For example, two basic ‘accounting identities’ from macroeconomics are:
β=sg
α=rβ
Here, s is the savings rate (i.e. fraction of total income that is saved, which in equilibrium equals investments into capital), g is the rate of economic growth, and r is the rate of return on capital. These equations are essentially definitions, but it’s easy to see that (in a simple macroeconomic model with one final good, two factors of production, etc.) β can be viewed as the capital-to-income ratio and α as capital’s share of income.
Note that from equations 1 and 2 it follows that rg=αs. Thus we see that r exceeds g in equilibrium/‘forever’ if and only if α>s - in other words, if and only if (on average across the whole economy) not all of the returns from capital are re-invested into capital.
(Why would that ever happen? Because individual actors maximize their own welfare, not aggregate growth. So e.g. they might prefer to spend some share of capital returns on consumption.)
Analog remarks apply to other situations where a basic model of this type is applicable.
Shouldn’t investing into the stock market be considered a source of average returns, by default? In the long run, the stock market grows at the same rate as GDP.
If you think you have some edge, that might be a reason to pick particular stocks (as I sometimes do) and expect returns above GDP growth.
But generically I don’t think the stock market should be considered a source of above-average returns. Am I missing something?
The stock market should grow faster than GDP in the long run. Three different simple arguments for this:
This falls out of the commonly-used Ramsey model. Specifically, because people discount the future, they will demand that their investments give better return than the general economy.
Corporate earnings should grow at the same rate as GDP, and stock price should grow at the same rate as earnings. But stock investors also earn dividends, so your total return should exceed GDP in the long run. (The reason this works is because in aggregate, investors spend the dividends rather than re-investing them.)
Stock returns are more volatile than economic growth, so they should pay a risk premium even if they don’t have a higher risk-adjusted return.
[Low confidence as I don’t really understand anything about finance.]
It sounds right to me that the stock market can’t grow more quickly than GDP forever. However, it seems like it has been doing so for decades, and that there is no indication that this will stop very soon—say, within 10 years.
(My superficial impression is that this phenomenon it somewhat surprising a priori, but that there isn’t really a consensus for what explains it.)
Therefore, in particular, for the window of time made available by moving spending from now to, say, in 1 year, it seems you can earn returns on the stock market that exceed world economic growth.
If we know that this can’t continue forever, it seems to me this would be more relevant for the part where I say “future longtermists would invest in the stock market rather than engaging in ‘average activities’ that earn average returns” etc.
More precisely, the key question we need to ask about any longtermist investment-like spending opportunity seems to be: After the finite window of above-average growth from that opportunities, will there still be other opportunities that, from a longtermist perspective, have returns that exceed average economic growth? If yes, then it is important whether the distant returns from investment-like longtermist spending end up with longtermists; if no, then it’s not important.
Hmm, my understanding is that the equity premium is the difference between equity returns and bond (treasury bill) returns. Does that tell us about the difference between equity returns and GDP growth?
A priori, would you expect both equities and treasuries to have returns that match GDP growth?
Yes, that’s my understanding as well.
I don’t know, my sense is not directly but I could be wrong. I think I was gesturing at this because I took it as evidence that we don’t understand why equities have such high return. (But then it is an additional contingent fact that these returns don’t just exceed bond returns but also GDP growth.)
I don’t think I’d expect this, at least not with high confidence—but overall I just feel like I don’t know how to think about this because I understand too little finance and economics. (In particular, it’s plausible to me that there are strong a priori arguments about the relationships between GDP growth, bond returns, and equity returns—I just don’t know what they are.)
Okay, sounds like we’re pretty much in the same boat here. If anyone else is able to chime in and enlighten us, please do so!
I thought about this for another minute, and realized one thing that hadn’t been salient to me previously. (Though quite possibly it was clear to you, as the point is extremely basic. - It also doesn’t directly answer the question about whether we should expect stock returns to exceed GDP growth indefinitely.)
When thinking about whether X can earn returns that exceed economic growth, a key question is what share of those returns is reinvested into X. For example, suppose I now buy stocks that have fantastic returns, but I spend all those returns to buy chocolate. Then those stocks won’t make up an increasing share of my wealth. This would only happen if I used the returns to buy more stocks, and they kept earning higher returns than other stuff I own.
In particular, the simple argument that returns can’t exceed GDP growth forever only follows if returns are reinvested and ‘producing’ more of X doesn’t have too steeply diminishing returns.
For example, two basic ‘accounting identities’ from macroeconomics are:
β=sg
α=rβ
Here, s is the savings rate (i.e. fraction of total income that is saved, which in equilibrium equals investments into capital), g is the rate of economic growth, and r is the rate of return on capital. These equations are essentially definitions, but it’s easy to see that (in a simple macroeconomic model with one final good, two factors of production, etc.) β can be viewed as the capital-to-income ratio and α as capital’s share of income.
Note that from equations 1 and 2 it follows that rg=αs. Thus we see that r exceeds g in equilibrium/‘forever’ if and only if α>s - in other words, if and only if (on average across the whole economy) not all of the returns from capital are re-invested into capital.
(Why would that ever happen? Because individual actors maximize their own welfare, not aggregate growth. So e.g. they might prefer to spend some share of capital returns on consumption.)
Analog remarks apply to other situations where a basic model of this type is applicable.
Ah, good point! This was not already clear to me. (Though I do remember thinking about these things a bit back when Piketty’s book came out.)