Question

Historically, investors holding corporate equities have earned a premium, or extra return for holding equities instead of bonds. Economists have assumed that the equity premium, which has averaged about 7 percent during the post-Depression period, is a measure of the compensation that investors require for taking on the extra risk inherent in equity investments (stocks). Recently, there has been a significant decline in the equity premium on stocks. Between 1990 and 2000, the value of U.S. corporate equities rose 425 percent, and, as a consequence, the return on a diversified stock portfolio has been much lower than its historic average and close to the return on U.S. government bonds. One possible explanation of a shrinking equity premium is the greater opportunity for portfolio diversification – the "mutual fund effect."

     How could the growth of mutual fund investing result in a smaller equity premium in the future? Carefully explain.

Answer 1

Growth of mutual fund investing is focused at continuously diversification of their portfolio and providing investors with low risk investments which are highly diversified across various sectors so even if there is a downside in the stock market, These Mutual Funds are not losing much because they have diversifed across various asset classes or they have also diversifed across various sectors which are defensive and aggressive so they have tried to eliminate non systematic risk to a large extent.

Mutual fund investing is believing in the philosophy of high diversification which will be eliminating the firm specific risk in the portfolio to a large extent and it will mean that there will be a lower level of risk which will be present in the overall portfolio and those can mostly be attributed to the systematic factors so these low risk factors are one of the important aspects of investment in these Mutual Funds at any stage because investor feels that they are providing a higher rate of return in the longer time frame so there will be a very low risk premium which will be taken by these Mutual Funds because they have already believed that they are diversifying the risk to a large extent and they are not taking high amount of risk in order to make a higher amount of Return so there is a presence of very low risk and there is also a subsequent project of low risk premium hence it can be said that emergence of the mutual funds has led to a very high amount of diversification and elimination of systematic risk to a large extent and that had formulated into higher rate of return in the portfolio in the longer run and low risk premium because investors feel that there are very low risk in accordance with investment with mutual funds.