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Perspectives on the Equity Risk Premium – Siegel CFA Institute Perspectives on the Equity Risk Premium Author(s): Jeremy J. Siegel Source: Financial Analysts Journal, Vol. 61, No. 6 (Nov. - Dec., 2005), pp. 61-73 Published by: CFA Institute Stable URL: http://www.jstor.org/stable/4480715 Accessed: 04/03/2010 18:01 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=cfa. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial Analysts Journal. http://www.jstor.org FINANCIAL ANALYSTS JOURNAL v R ge Perspectives on the Equity Risk Premium JeremyJ. Siegel The equity risk premium, or the difference between the expected returnson stocks and on risk-freeassets, has commanded the atten- tion of both professionaleconomists and investmentpractitioners for many decades. In the past 20 years, more than 320 articles,enough to fill some 40 economics and finance journals, have been published with the words "equitypremium" in the title. The intense interest in the magnitude of the premium is not surprising. The difference between the return on stocks and the return on bonds is criticalnot only for asset allocation but also for wealth projectionsfor individual investors,foundations, and endow- ments. One of the most asked questions by investors is: How much more can I expect to earn from shifting from bonds to stocks? Academicinterest in the equity premiumsurged afterMehra and The equity risk Prescottpublished a seminal article in 1985 titled "The Equity Pre- mium:A Puzzle."By examiningthe behaviorof the stock marketand premium aggregate consumption, they showed that the equity risk premium, under the usual assumptions about investor behavior toward risk, determines asset should be much lower than had been calculatedfrom the historical data. Indeed, Mehraand Prescottstated that the equity premium in allocations, the U.S.markets should be, at most, 0.35percent instead of the approx- imately 6 percentpremium computed from data going back to 1872. projections of The Mehra-Prescott research raised the following question: Have investors been demanding-and receiving-"too high" a wealth, and the cost return for holding stocks based on the fundamental uncertaintyin the economy, or are the models that economists use to describe of capital, but we do investorbehavior fundamentally flawed? If the returnshave been too high, then analysts can justify increased asset allocation to equities not have a simple and reducedallocation to bonds;if the models are flawed, economists need to develop new models to describeinvestor behavior. My discussion of the equity risk premium will be divided into model that explains three parts: (1) a summary of the data used to calculate the equity premium and discussion of potential biases in the historicaldata, (2) the premium. analysis of the economic models, and (3) discussion of the implica- tions of the findings for investors and for forecasts of the future equity premium.1 Historical Returns on Stocks and Bonds In this section, I present historicalasset returnssince 1802,define the equity premium, and discuss biases in the historicaldata that affect future estimates of the equity premium. JeremyJ. Siegelis theRussell E. PalmerProfessor of Finance at theWharton School,University of Pennsylvania,Philadelphia. (?2005, CFA Institute www.cfapubs.org 61 FINANCIAL NALYSTS JOURNAL iZeffec (10 ns Equity Returns. The historical returns on return on stocks can deviate substantially from the stocks, bonds, and bills and the equity risk premium long-run average. Since World War II, returns in for the U.S. markets from 1802 through 31 Decem- major market cycles have fluctuated from a 10.02 ber 2004 are in Table 1.2 Both the arithmetic mean percent annual real equity return in the bull market of the annual data, which is the "expected return" of 1946-1965 to a -0.36 percent annual real equity used in the capital asset pricing model (CAPM), and return in the bear market of 1966-1981; in the great the compound (or geometric) return, which is the bull market of 1982-1999, the return doubled the return most often used by individual and profes- 203-year average. sional investors, are given in Table 1.3 The last col- umns display the equity risk premium in relation to Fixed-income Returns. The middle columns both long-term U.S. government bonds and T-bills. in Table 1 show that real bond returns, in contrast Returns and premiums are broken down into two to stocks, have experienced a declining trend in the past two centuries. From subperiods in Panel A, into three major subperiods 1802 through 2004, the average annual compound real return on long- in Panel B, and into the major bull and bear markets term bonds was about half the equity return, but since World War II in Panel C. in the 19th century, real bond returns were nearly The stability of the real (inflation-adjusted) 5 percent. Since the end of World War II, the bond return on stocks over all long periods is impres- return has averaged less than 1.50 percent. The 3.31 sive.4 The compound annual real return on equity percent average real return over the last two cen- has averaged 6.82 percent over the past 203 years turies is approximately equal to the real growth of and, as Panels B and C show, settled between 6.5 the economy, but in the post-World War II period, percent and 7.0 percent for each of the three major real returns on bonds have fallen far below eco- subperiods and for the post-World War II data. nomic growth.5 This return is about twice the growth of the econ- The real return on short-dated T-bills has fallen omy and includes the risk premium above risk-free even more sharply than the return on bonds over the assets that investors have demanded to hold stocks. past two centuries. For the entire period, real T-bill When the period for which stock returns are returns averaged 2.84 percent, 67 bps below the analyzed shrinks to one or two decades, the real return on long-term bonds. Average short-term Table 1. Historical Real Stock and Bond Returns and the Equity Premium Real Return Stock Return minus Return on: Stocks Bonds Bills Bonds Bills Period Comp. Arith. Comp. Arith. Comp. Arith. Comp. Arith. Comp. Arith. A. Long periods to present 1802-2004 6.82% 8.38% 3.51% 3.88% 2.84% 3.02% 3.31% 4.50% 3.98% 5.36/ 1871-2004 6.71 8.43 2.85 3.24 1.68 1.79 3.86 5.18 5.03 6.64 B. Major subperiods 1802-1870 7.02% 8.28% 4.78% 5.11% 5.12% 5.40% 2.24% 3.17% 1.90% 2.87% 1871-1925 6.62 7.92 3.73 3.93 3.16 3.27 2.89 3.99 3.46 4.65 1926-2004 6.78 8.78 2.25 2.77 0.69 0.75 4.53 6.01 6.09 8.02 C. Post-World War IIfull sample, bull markets,and bearmarkets 1946-2004 6.83% 8.38% 1.44% 2.04% 0.56% 0.62% 5.39% 6.35% 6.27% 7.77% 1946-1965 10.02 11.39 -1.19 -0.95 -0.84 -0.75 11.21 12.34 10.86 12.14 1966-1981 -0.36 1.38 -4.17 -3.86 -0.15 -0.13 3.81 5.24 -0.21 1.51 1982-1999 13.62 14.30 8.40 9.28 2.91 2.92 5.22 5.03 10.71 11.38 1982-2004 9.47 10.64 8.01 8.74 2.31 2.33 1.46 1.90 7.16 8.32 Note: "Comp." stands for "compound"; "Arith." stands for "arithmetic." 62 www.cfapubs.org ?2005, CFA Institute FINANCIAL ANALYSTS JOURNAL iZe ff 0 rates were 34 bps above long-termrates for 1802- States since 1802 has been 5.36 percent and since 1870, but they were 57 bps below long rates from 1926, has been 8.02 percent. When geometricmean 1871through 1925 and have been 156bps below long returnsare used, the equitypremium shrinks to 3.98 ratessince 1926. percentsince 1802and 6.09percent since 1926.If we The increase in the spread between long rates calculate the equity premium against long-dated and short rates was caused partly by the increased (instead of short-term)bonds, the compound pre- liquidity of the T-billmarket, which lowered short mium falls farther-to 3.31percent over the past 202 rates, and partly by the increase in the inflation years and 4.53 percentsince 1926. premium investors have required on long-term So, over the period from 1926 to the present, bonds over much of the post-World War II period.
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