equity premium Concepts

Smarter Investing

by Tim Hale · 2 Sep 2014 · 332pp · 81,289 words

and French, 2012). The authors concluded: ‘In a nutshell, the message … is that long time periods are required to be reasonably sure that the average equity premium, the average size premium, or the average value premium will be positive … Indeed, no matter how long the investment period, one can never be perfectly

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of returns experienced across markets and over different time periods. Points of note include the fact that even over long periods of time, a strong equity premium is not assured, as amply demonstrated by the experience of Austria. Global diversification makes sense. Equities have outstripped bonds and cash by a material degree

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risk premium but as the Economist succinctly put it in 2003: ‘Yes, over long periods equities have done better than bonds. But there is no equity “premium” – in the sense of a fairly predictable excess over bond returns on which investors can rely … Searching for a consistent, God-given premium is a

The Long Good Buy: Analysing Cycles in Markets

by Peter Oppenheimer · 3 May 2020 · 333pp · 76,990 words

.bloomberg.com/news/articles/2019–06–25/austria-weighs-another-century-bond-for-yield-starved-investors 2 Mehra, R., and Prescott, E. C. (1985). The equity premium: A puzzle. Journal of Monetary Economics, 15(2), 145–161. Chapter 3 The Equities Cycle: Identifying the Phases Although there are long-term shifts in

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. Journal of Finance, 53(6), 1975–1999. Ferguson, N. (2012). The ascent of money. London, UK: Penguin. Fama, E. F., and French, K. (2002). The equity premium. Journal of Finance, 57(2), 637–659. Ferguson, R. W. (2005). Recessions and recoveries associated with asset-price movements: What do we know? Stanford Institute

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dominates. Variety [online]. Available at https://variety.com/2019/film/news/box-office-record-disney-dominates-1203098075/ Mehra, R., and Prescott, E. C. (1985). The equity premium: A puzzle. Journal of Monetary Economics, 15(2), 145–161. Minsky, H. P. (1975). John Maynard Keynes. New York, NY: Springer. Modigliani, E., and Blumberg

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, F. (2019). Stock market analysis: A review and taxonomy of prediction techniques. International Journal of Financial Studies, 7(2), 26. Siegel, J. J. (1992). The equity premium: Stock and bond returns since 1802. Financial Analysts Journal, (48)1, 28–38. Siegel, L. B. (2017). The equity risk premium: A contextual literature review

Triumph of the Optimists: 101 Years of Global Investment Returns

by Elroy Dimson, Paul Marsh and Mike Staunton · 3 Feb 2002 · 353pp · 148,895 words

the United States and the United Kingdom, and emphasize the need to consider the total payout as well as cash dividend payments. 1.4 The equity premium Investment in equities over the twentieth century has proved rewarding, but has been accompanied by correspondingly greater risks. In chapter 12, we examine the historical

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the 101 years from 1900–2000, contrasting this with the equivalent ten-year premia relative to bills. Obviously, over periods when bonds performed poorly, the equity premium relative to bonds has tended to exceed the premium relative to bills, and vice versa. This is especially noticeable over the second half of the

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13.7 percent. Figure 12-5: Rolling ten-year US equity risk premia relative to bonds and to bills, 1909–2000 20 Percentage return Equity premium vs. bonds 15 Equity premium vs. bills 10 5 0 -5 -10 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Chapter 12 The equity risk

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Investment Returns 172 Figure 12-6: Worldwide annualized equity risk premia relative to bonds and bills, 1900–2000 8 Annualized percentage return Equity premium vs. bonds 7 6.7 Equity premium vs. bills 6.2 6.3 6 5 4 4.4 4.5 4.6 UK Can Wld Neth 4.7 4.9

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more recently. Nevertheless, two very important conclusions stand out. First, our evidence does not fully support Jorion and Goetzmann’s (1999) claim that "the high equity premium obtained for US Chapter 12 The equity risk premium 175 [and, by implication, UK] equities appears to be the exception rather than the rule." While

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by Mehra and Prescott (1985), thus remains a source of controversy. As Kocherlakota (1996) and Shleifer (2000) point out, traditional finance theory suggests that the equity premium should be much smaller than the (US) historical average. Chapter 13 The prospective risk premium 181 As one might expect, there are competing theories that

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emphasizes historical and prospective equity risk premia calculated relative to bills. We select bills because they are the more commonly used basis for defining the equity premium—reflecting the fact that only treasury bills can really be considered close to risk free. Nearly all of our discussion, however, applies equally well to

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equity risk premium was its own past average. Certainly, researchers such as Goyal and Welch (1999) are unable to find variables that robustly predict the equity premium better than simply assuming that the premium will be “like it has been.” Welch (2000) casts light on whether academic finance professionals do, in fact

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.5 percent as compared to 7.5 percent over the following fifty-one years. Chapter 13 The prospective risk premium 189 Figure 13-5: The equity premium relative to bills: first half-century versus next fifty-one years Annualized arithmetic risk premium relative to bills (%) Before 1950 14 13 1950–2000 11

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14 Implications for investors Why are stocks thought to perform so much better, over the long run, than government securities? The explanation is that the equity premium has been large relative to stock market volatility. In Valuing Wall Street, Smithers and Wright (2000) define the stable value of the historic real return

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top and bottom deciles, and the median. Note, however, the contrast with the US and UK illustrations discussed in the previous section. While the mean equity premium is not dissimilar from the previous examples, the dispersion of premia is much greater. Furthermore, the red line shows that the premia from earlier dates

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in making projections from the past into the future, and we noted the large historical rewards from equities: this is Mehra and Prescott’s (1985) equity premium puzzle that stocks have provided a higher reward than can be explained by theory. Alternatively, the large ex post risk premium may reflect rewards from

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average for the US and UK; see Table 12-1), or 24 percent (which might apply to more poorly diversified portfolios). We assume that the equity premium is lognormally distributed, and plot the first, tenth, fiftieth, ninetieth, and ninety-ninth percentiles of the distribution, over intervals of ten, twenty, thirty, forty, and

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/bill returns is relatively insensitive to the tax rate since taxes are deducted from bond returns as well as from equity returns. The after-tax equity premium is therefore reasonably robust to tax assumptions. Taxation does not dampen the case for equity investing. The decimating impact on returns of taxation does, however

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become a resource for the investment manager, professional advisor and tax-collecting authority. What would happen if investors were to become convinced that the annualized equity premium might indeed be little more than 3 percent? This would impose cost pressure on mutual funds. Many investors are unlikely to be willing, on a

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bond yields are, of course, much higher than the twentieth century average. Compared to the equity risk premium from recent decades, today’s forward-looking equity premium is lower. This changing balance in expected rewards has significant implications for individual investors. It highlights the importance of the investor’s asset allocation strategy

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index funds. That can be rational since it optimizes the portfolio’s reward-to-risk ratio. Our assertion in this book, however, is that the equity premium is markedly lower than many people suggest. The reward from passive investing must therefore be lower, in relative terms, than was previously thought. For skilled

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was previously surmised. In addition, their returns were enhanced by once-off re-ratings. Taking the evidence of other countries and of a lower prospective equity premium, the apparent superiority of equities will in future years be attenuated. We show that common stocks cannot be regarded as a safe bet for the

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should not, we suggest, be judged for a further one hundred years. Even then, note that with 201 observations the standard error associated with historical equity premium estimates will still be of the order of 1–1½ percent. Chapter 15 Implications for companies We have analyzed the long-term performance of the

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observed, but after publication of the privately distributed predecessor to this book, as well as extensive research by others, it seems that estimates of the equity premium also fell. Since both components declined, it follows that the required return on equity capital is lower than it was in the mid-to-late

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same time, the equity risk premium has either fallen or is perceived to have fallen. With a decline in real interest rates, in the estimated equity premium, and in inflation, required returns are likely to be lower than many companies’ capital budgeting systems demand. Large corporations generally claim to base investment decisions

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to expected market rates of return; these rates have fallen for equities, and some actuarial valuations still need to adjust to current estimates of the equity premium. Shortfall analysis focuses on setting asset allocation policy in the light of probability limits for longterm performance. Not only is this controversial in its own

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1940 1950 1960 1970 1980 1990 2000 Chapter 18 Australia 233 Table 18-3: Australian equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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238 Triumph of the Optimists: 101 Years of Global Investment Returns Table 19-3: Belgian equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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1940 1950 1960 1970 1980 1990 2000 Chapter 20 Canada 243 Table 20-3: Canadian equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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248 Triumph of the Optimists: 101 Years of Global Investment Returns Table 21-3: Danish equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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1940 1950 1960 1970 1980 1990 2000 Chapter 22 France 253 Table 22-3: French equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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of the Optimists: 101 Years of Global Investment Returns Table 23-3: German equity risk premia over various periods, 1900–2000 Fromf Premium* Tob Equity premium versus bills Equity premium versus bonds * 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989 2000 1

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1940 1950 1960 1970 1980 1990 2000 Chapter 24 Ireland 263 Table 24-3: Irish equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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268 Triumph of the Optimists: 101 Years of Global Investment Returns Table 25-3: Italian equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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1940 1950 1960 1970 1980 1990 2000 Chapter 26 Japan 273 Table 26-3: Japanese equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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278 Triumph of the Optimists: 101 Years of Global Investment Returns Table 27-3: Dutch equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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1960 1970 1980 1990 2000 Chapter 28 South Africa 283 Table 28-3: South African equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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288 Triumph of the Optimists: 101 Years of Global Investment Returns Table 29-3: Spanish equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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index published in the journal Affarsvarlden, plus the dividend income estimated by Frennberg and Hansson (1992b). De Ridder (1989) provides further information on the Swedish equity premium. The government bond series uses data for 1900–18 from The Economist. For 1919–49 the returns are for perpetuals, and after that the series

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1940 1950 1960 1970 1980 1990 2000 Chapter 30 Sweden 293 Table 30-3: Swedish equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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Triumph of the Optimists: 101 Years of Global Investment Returns Table 31-3: Swiss equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills (from 1911) Equity premium versus bonds (from 1911) Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959

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1950 1960 1970 1980 1990 2000 Chapter 32 United Kingdom 305 Table 32-3: UK equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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310 Triumph of the Optimists: 101 Years of Global Investment Returns Table 33-3: US equity risk premia over various periods, 1900–2000 Premium Equity premium versus bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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1950 1960 1970 1980 1990 2000 Chapter 34 World 315 Table 34-3: World equity risk premia over various periods, 1900–2000 Premium Equity premium versus US bills Equity premium versus bonds Fromf Tob 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 1909 1919 1929 1939 1949 1959 1969 1979 1989

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dividends: changing firm characteristics or lower propensity to pay? Journal of Financial Economics 60: 3–43 Fama, E.F., and K.R. French, 2002, The equity premium. Journal of Finance, forthcoming References 321 Firer, C., and H. McLeod, 1999, Equities, bonds, cash and inflation: historical performance in South Africa 1925–1998. The

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choice between dividends and stock repurchases. Journal of Financial Economics 57: 309–54 Jagannathan, R., E.R. McGrattan, and A. Scherbina, 2001, The declining US equity premium. Working paper 8172, National Bureau of Economic Research Jog, V., and B. Li, 1995, Price related anomalies on the Toronto Stock Exchange. ASAC 1995 Conference

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, D.B., 1983, Size-related anomalies and stock return seasonality: further empirical evidence. Journal of Financial Economics 12: 473–90 Kocherlakota, N.R., 1996, The equity premium: it’s still a puzzle. Journal of Economic Literature 34: 42–71 Laforest, P., and P. Sallee, 1977, Le pouvoir d’achat des actions, des

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and equities under alternative holding periods. Journal of Portfolio Management 19(4): 30–36 Li, H., and Y. Xu, 2000, Can survival bias explain the equity premium puzzle? Working paper, Cornell University Graduate School of Management Litzenberger, R.H., and K. Ramaswamy, 1979, The effect of personal taxes and dividends on capital

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. American Economic Review 70: 1018–21 Meghen, P.J., 1970, Statistics in Ireland. Dublin: Institute of Public Administration Mehra, R., and E. Prescott, 1986, The equity premium: a puzzle. Journal of Monetary Economics 15: 145–61 Merrett, A., and A. Sykes, 1963, Return on equities and fixed interest securities 1919–1963. District

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? Financial Analysts Journal 30: 48–54 Spoerer, M., and N. Foidl, 1999, Survival of German firms between 1936 and 1951 and the implications for the equity premium puzzle. Working paper, University of Hohenheim Stattman, D., 1980, Book values and expected stock returns. Unpublished MBA Honours paper, University of Chicago Stehle, R., 1997

Portfolio Design: A Modern Approach to Asset Allocation

by R. Marston · 29 Mar 2011 · 363pp · 28,546 words

. large-cap stocks had a compound real return of 6.2 percent. The difference between these two returns is often called the “equity premium”. Chapter 2 will discuss this equity premium in detail. The period prior to 1951 was no better. The real return on bonds between 1926 and 1950 was 2.7 percent

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than the risk-free return. The excess return of stocks over the risk-free return has been given a specific name, the equity premium. Using geometric averages, the equity premium is defined as Equity premium = (1 + rS&P )/(1 + rF ) − 1 = (1 + 0.107)/(1 + 0.048) − 1 = 5.6% where rS&P is the return

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on the S&P 500 and rF is the risk-free Treasury bill return.5 Sometimes the equity premium is defined by using the long-term bond rather than the risk-free return in which case the premium would be 4.4 percent rather

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period from 1926 to present is studied, a period that includes the depression of the 1930s, the equity premium (defined relative to the risk-free return) is 5.9 percent. However it is defined, the equity premium is remarkably large. This premium has provided equity investors with a rich reward for bearing the extra

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risk of owning equities. In a landmark study more than two decades ago, Mehra and Prescott (1985) showed that the equity premium is inconsistent with reasonable levels of risk aversion. They called the premium a puzzle. Since then, scores of finance researchers have set out to develop

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theoretical models of investor behavior that could explain the size of the premium.6 Researchers have also studied the equity premium in other countries. A book by Dimson, Marsh, and Staunton (2002) estimates the equity premium for 16 industrial countries from 1900 to 2000 as ranging P1: OTA/XYZ P2: ABC c02 JWBT412-Marston

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20, 2010 16:59 Printer: Courier Westford 24 PORTFOLIO DESIGN from 1.8 percent for Denmark to 7.4 percent for France, with an average equity premium of 4.9 percent. Wise investors don’t spend too much time agonizing over the source of the premium. They simply take advantage of it

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by focusing on equities in their portfolios. HOW MUCH MORE ATTRACTIVE ARE STOCKS THAN BONDS? Many investors, though, see the equity premium as a necessary price for the extra risk of investing in stocks. After all, the standard deviation of the S&P 500 series is 14

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stock returns. A 2.2 percent real return on bonds seems small when earned by an asset with a 9.5 percent standard deviation. The equity premium is seen in a new light once real returns are analyzed. Consider the following alternative investment strategies followed by a younger investor saving for retirement

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invested at the 6.7 percent compound real return on stocks earned since 1951 increases to $366,000, or a 266 percent compound return. The equity premium may provide the extra return for a more comfortable retirement. Figure 2.2 shows the accumulation of (tax-deferred) wealth under the two alternative strategies

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-Marston December 20, 2010 16:59 Printer: Courier Westford 33 Long-Run Returns on Stocks and Bonds Fama and French’s (2002) study of the equity premium provides alternatives estimates of stock returns based on these corporate fundamentals. According to Fama and French, the average return on equity can be estimated in

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any case, as will be shown below, the inclusion of years 1926 through 1950 does not change conclusions regarding long-term real returns or the equity premium. 2. Nine recessions is admittedly not a large statistical sample, but it is certainly a larger sample than can be found when we study emerging

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. The arithmetic average for long-term bonds is higher than that of medium-term bonds. 11. Arnott and Bernstein (2002), for example, conclude that the equity premium over the risk-free rate is zero and that a sensible expectation for future real returns on stocks and bonds is 2 to 4 percent

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is 8.3 percent for 1872–1950. 18. Their estimate in Table IV of their paper is for the real equity premium, not the real equity return. But once the long-term equity premium is converted into a return, the estimate is about 8.3 percent for the real equity return based on actual

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risk as the all-bond portfolio. But the return is 2.5 percent higher (over the sample period from January 1951 to December 2009). The equity premium is evidently at work here. To the right of this portfolio, higher returns must be accompanied by higher risk. Thus a portfolio with (say) 70

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Returns over S&P 500 Alternative Asset Index FTSE NAREIT HRFI Fund of Funds Credit Suisse/Tremont Hedge Fund DJ UBS Commodity Venture Capital Private Equity Premium over S&P 500 Estimated Return Period of Measurement +1.6% +0.0% +1.6% 11.2% 9.4% 11.2% 1972–2009 1990–2009

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. French, 1992, “The Cross-Section of Expected Stock Returns,” Journal of Finance (June), pp. 427–465. Fama, Eugene F., and Kenneth R. French, 2002. “The Equity Premium,” The Journal of Finance (April), pp. 637–659. Fama, Eugene, and Kenneth French, 1993. “Common Risk Factors in the Returns on Stocks and Bonds,” Journal

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Stock Return Seasonality,” Journal of Financial Economics (June), 13–22. Keynes, John M., 1930, A Treatise on Money. London: Macmillan. Kocherlakota, Narayana R., 1996, “The Equity Premium: It’s Still a Puzzle,” Journal of Economic Literature (March) pp. 42–47. Kravis, Irving B., Z. Kenessey, Allan Heston, and Robert Summers, 1975, A

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, “Risk-Adjusted Performance of Portfolios,” Journal of Investment Consulting, Vol. 7, No. 1, (Summer): pp. 46–54. Mehra, Rajnish, and Edward C. Prescott, 1985, “The Equity Premium: A Puzzle,” Journal of Monetary Economics 15 (March): 145–161. Merrill Lynch-Capgemini, 2008, World Wealth Report. Metrick, Andrew, 2007, Venture Capital and the Finance

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/d QC: e/f JWBT412-Marston T1: g January 6, 2011 10:45 Printer: Courier Westford 333 Index equity hedge, 172 equity market neutral, 171 equity premium, 23–24 equity returns, 30–32, 35–36 estimates, stock returns, 32–34 Euro bond, 142 Euro exchange rates, 81–82 Europe, 104 European bond

Expected Returns: An Investor's Guide to Harvesting Market Rewards

by Antti Ilmanen · 4 Apr 2011 · 1,088pp · 228,743 words

NOTES Part II - A dozen case studies Chapter 8 - Equity risk premium 8.1 INTRODUCTION AND TERMINOLOGY 8.2 THEORIES AND THE EQUITY PREMIUM PUZZLE 8.3 HISTORICAL EQUITY PREMIUM 8.4 FORWARD-LOOKING (EX ANTE OBJECTIVE) LONG-TERM EXPECTED RETURN MEASURES 8.5 SURVEY-BASED SUBJECTIVE EXPECTATIONS 8.6 TACTICAL FORECASTING FOR

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market-timing approaches. A broader mindset naturally leads to questioning the traditional 60/40 portfolio which relies excessively on one source of excess returns (the equity premium) and which therefore has highly concentrated risk (more than 90% of portfolio volatility is due to equities). • The strategy style perspective is especially important

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time the market were deemed a particularly wasteful form of active trading because moving from equities to cash implies forfeiting the large and presumably constant equity premium. Such restrictive theories did not prove sufficient to explain real market behavior. As new evidence accumulated, both academic and investor opinions evolved:• In recent

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substantial career risk); the directional bet is highly concentrated (unlike security selection that at least benefits from diversified exposures); and cash holdings miss out the equity premium (which was seen to be especially high before the 2000s’ experience). The boom–bust cycles of the past decade shifted the consensus to embrace

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. Market data cannot distinguish between rational and irrational stories, and both may have contributed to the observed return predictability. It is not just the equity premium that varies predictably over time—most premia do. Such time variation is most obvious in the fluctuations of credit spreads, but I will review many

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returns is hard enough without misinterpreting available data. We need to evaluate critically the published historical returns of any asset class or strategy (chapters on equity premium, alternatives, and dynamic strategies focus on various biases and data problems). And when ex ante measures are available, we need to recognize their pitfalls

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compared with fundamentals. However, rational time variation in risk premia is an alternative or, more likely, a complementary explanation for such empirical evidence. The equity premium puzzle refers to the fact that the high historical average return of equities over riskless assets is hard to justify using standard macroeconomic models unless

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high amidst stable mild inflation and low macro-volatility, which is not a promising sign for future multiple expansion. • Standard economic models suggest that the equity premium should be negligible (<1%). A cottage industry of academic papers offers diverse explanations for the puzzle of stocks’ much stronger historical outperformance. • Survey forecasts

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across sources and over time. Retail investor expectations appear extrapolative and procyclical, professional investor views less so. The latter tend to predict a long-run equity premium of 3% to 4%—below the historical average but above some estimates from valuation models. Academics’ estimates average near 6%, the higher value apparently

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reflecting benign 20th-century experience and/or the widespread use in academia of the future-equals-past model for the equity premium. • Valuation, cyclical, and sentiment indicators can be useful for market timing, but all such relations are fragile. 8.1 INTRODUCTION AND TERMINOLOGY It is

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and real (inflation-adjusted) returns. This entire analysis focuses on pretax returns [1]. The other important distinction among equity premium concepts is between the ex post equity premium (historical realized excess return) and the ex ante equity premium (forward-looking excess return):• both can be measured either as an arithmetic average or a geometric average; •

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return expectations (that are possibly irrational). Thus, the label “ERP” can be misleading if non-risk considerations cause equities’ ex ante return advantage. The equity premium is ideally computed for stock market indices that weight each constituent stock by its market capitalization. Early research also analyzed equally weighted stock indices that

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theories from economic fundamentals like consumption, such theories have found it hard to explain why equities have historically outperformed bonds by several percentage points. The equity premium puzzle refers to the difficulty of explaining the magnitude of the observed (historical) equity risk premium (4 to 8%) in the context of a

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about long-run growth rates. Academics have developed theoretical models on this theme, while empiricists argue that the secular decline in dividend yields and other equity premium proxies has been matched by a secular decline in macroeconomic volatility. • Straddling the above explanations, the legacy of the Great Depression may have sustained

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and losses. The model thus implies that investors’ risk attitudes become more conservative in down-markets. The next section shows that estimates of the equity premium have edged lower since the 1990s. During the Great Moderation years, it was popular to argue that lower macro-volatility and investor learning about equities

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experience. Yet, it remains plausible that the fair premium has declined somewhat due to lower trading costs and better global diversification opportunities. 8.3 HISTORICAL EQUITY PREMIUM Table 8.1 and Figure 8.1 recap the U.S. experience since the 19th century, documenting compound (geometric) nominal and real returns as

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); the latter may be combined with carry to arrive at estimates of expected return. I first discuss investors’ return forecasts, then academic views on the equity premium, and finally economists’ GDP forecasts and analysts’ earnings growth predictions. While there are many surveys of investors’ equity market views, the questions are often

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2008–2009. The thin line shows one natural benchmark—economists’ consensus forecasts of long-term output growth, which have been pretty sensible. Note that equity premium estimates that rely on analyst forecasts will inherit their overoptimism. Figure 8.15. Analyst forecasts of long-term earnings growth are overoptimistic (but less so

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returns was a theme in three influential papers after the 2000 equity bust: Arnott–Bernstein (2002), Fama–French (2002), and Ibbotson–Chen (2003). The equity premium puzzle was introduced in Mehra–Prescott (1985) and the subsequent academic literature thoroughly reviewed in Mehra (2008). My highlighted explanations include Rietz (1988), Benartzi–Thaler

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about historical performance, so the relevance for future investing relies on the “future-equals-past” mindset that I criticized earlier in the context of equity premium. However, as investors we must first be convinced that an opportunity has existed in the past before we can meaningfully debate its sustainability. Forward-

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began to re-explore the puzzling success of currency carry strategies; their risk-adjusted returns appeared better than those that motivated the literature on the equity premium puzzle and the value puzzle. Trading costs and market frictions were among the early “explanations” but currencies are highly liquid and the carry strategy

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these factors tend to offer larger ex ante risk premia following adverse shocks. • The growth factor is closest to the equity market factor and the equity premium. It captures general economic growth prospects but is also closely related to market risk aversion. • Long-lived risky assets reflect both secular and cyclical

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all assets (equity and debt) together, but this return could be divided between a low real riskless rate and a high equity premium or a high real rate and a low equity premium—depending on investor preferences (impatience, risk aversion, consumption smoothing, and liquidity needs); the relative sizes of different asset classes; and

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website, Brevan Howard, own calculations. 16.5 TIME-VARYING GROWTH PREMIUM Because the growth premium is so closely related to the equity premium, much of the discussion about a time-varying equity premium in Chapter 8 applies here. Let us recall the debate regarding the countercyclical pattern in risky assets’ expected returns. Many

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structure data from the Federal Reserve Board and from Citigroup to estimate forward rates for Treasury bills. Source notes. Survey data are used for polling equity premium views in Welch (2000, 2009), Vissing–Jorgensen (2003), Amromin–Sharpe (2008), and Graham–Harvey (2010), and for extracting better bond premium estimates in Best

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cost averaging is suboptimal. If investors postpone equity investments despite having earned and saved a given amount of cash income, they delay earning the equity premium and thus reduce long-run returns. If the optimal portfolio is a given combination of riskless assets and risky equity, theory advises instantly allocating

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(2010), “Inflation risk and the inflation risk premium,” Economic Policy, 25, 755–806. Benartzi, Shlomo; and Richard Thaler (1995), “Myopic loss aversion and the equity premium puzzle,” Quarterly Journal of Economics 110, 75–92. Benzoni, Luca; Pierre Collin-Dufresne; and Robert S. Goldstein (2010), “Explaining asset pricing puzzles associated with the

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the Journal of Financial Economics. Chen, Long; Pierre Collin-Dufresne; and Robert S. Goldstein (2009), “On the relation between the credit spread puzzle and the equity premium puzzle,” Review of Financial Studies, 22(9), 3367–3409. Chen, Long; David Lesmond; and Jason Zhansun Wei, (2007), “Corporate yield spreads and bond liquidity,”

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(2008), “Decomposing the yield curve,” University of Chicago working paper. Cogley, Timothy; and Thomas J. Sargent (2008), “The market price of risk and the equity premium: A legacy of the Great Depression?” Journal of Monetary Economics 55(3), 454–476. Cohen, Lauren; and Andrea Frazzini (2008), “Economic links and predictable returns

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dividends: Changing firm characteristics or lower propensity to pay,” Journal of Financial Economics 60, 3–43. Fama, Eugene F.; and Kenneth R. French (2002), “The equity premium,” Journal of Finance 57 (April), 637–659. Fama, Eugene F.; and Kenneth R. French, (2006a), “Profitability, investment, and average returns,” Journal of Financial Economics

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Research discussion paper 7734. Ferguson, Niall (2007), The Ascent of Money: A Financial History of the World, London: Penguin/ Allen Lane. Fernandez, Pablo (2007), “Equity premium: Historical, expected, required and implied,” IESE Business School working paper. Fernandez, Pablo (2009), “Market risk premium used in 2008 by professors: A survey with 1

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,400 answers,” IESE Business School working paper. Fernandez, Pablo; Javier Aguirremalloa; and Heinrich Liechtenstein (2008), “The equity premium puzzle: High required premium, undervaluation and self fulfilling prophecy,” IESE Business School working paper. Ferson, Wayne E.; and Campbell R. Harvey (1991), “The variation

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the volatility of the nominal excess return on stocks,” Journal of Finance 48(5), 1779–1801. Goetzmann, William N.; and Roger G. Ibbotson (2006), The Equity Premium: Essays and Explorations, Oxford University Press. Goetzmann, William N.; Akiko Watanabe; and Masahiro Watanabe (2009), “Investor expectations, business conditions, and the pricing of beta

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New Era, annual report. Mehra, Rajnish, Ed. (2007), Handbook of the Equity Risk Premium, Elsevier Science. Mehra, Rajnish; and Edward C. Prescott (1985), “The equity premium: A puzzle,” Journal of Monetary Economics 15, 145–161. Mei, Jianping; and Michael Moses (2002), “Art as an investment and the underperformance of masterpieces,” American

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commercial real estate,” Review of Financial Studies, 23(9), 3469–3519. Polk, Christopher; Samuel Thompson; and Tuomo Vuolteenaho (2006), “Cross-sectional forecasts of the equity premium,” Journal of Financial Economics 81, 101–141. Pollet, Joshua; and Mungo Wilson (2008), “Average correlation and stock market returns,” forthcoming in the Journal of Financial

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enhanced-commodity indices,” working paper, available at SSRN: http://ssrn.com/abstract=1648816 Rapach, David; Jack Strauss; and Guofu Zhou (2009), “Out-of-sample equity premium prediction: Combination forecasts and links to the real economy,” working paper, available at SSRN: http://ssrn.com/abstract=1257858 Rebonato, Riccardo (2007), Plight of the

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? Evidence from expectations and actions,” NBER Macroeconomics Annual 2003. Vissing-Jorgensen, Annette; and Moskowitz, Tobias J. (2002), “The returns to entrepreneurial investment: A private equity premium puzzle?” American Economic Review 92(4), 745–778. Wallison, Peter J. (2009), “Not a failure of capitalism, a failure of government,” in Insights into the

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financial economists on the equity risk premium and on financial controversies,” Journal of Business, 73(4), 501–537. Welch, Ivo (2009), “The results of the equity premium January 2009 survey,” working paper, available at SSRN: http://ssrn.com/abstract=1519544 Welch, Ivo; and Goyal, Amit (2008), “A comprehensive look at the

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empirical performance of equity premium prediction,” Review of Financial Studies 21, 1455–1508. Wermers, Russ (2000), “Mutual fund performance: An empirical decomposition into stock-picking talent, style, transaction costs,

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risk time-varying betting against beta (BAB) biases attention behavioral finance confirmation conservatism currency carry downgrading extrapolation forward rate hedge funds heuristic simplifications high equity premium hindsight historical returns learning limits memory momentum overconfidence overfitting overoptimism reporting representativeness reversal tendencies self-attribution self-deception survey data terminology volatility selling binary timing

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bonds CRP illiquid assets sample-specific results Treasuries risk arbitrage beta risk correlation covariance risk CRP currency carry distress duration risk endogenous return and risk equity premium puzzle equity value strategies hedge funds neglected risks PE funds portfolios skewness systematic risk tactical forecasting volatility see also reward—risk; tail risks risk-

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also commodity momentum Triumph of the Optimists (Dimson, Marsh, and Staunton) turn-of-the-month effect twelve-month periodicity UIP see uncovered interest parity uncertainty equity premium puzzle inflation structural volatility uncovered interest parity (UIP) underreaction United States (U.S.) 1988—2007 vs. 1968—1987 bonds equity growth ERP historical records

The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money

by Steven Drobny · 18 Mar 2010 · 537pp · 144,318 words

aware of any plan that had an explicitly defined allocation to the illiquidity premium the way they had, for example, explicitly defined allocations to the equity premium or fixed income risk premium. Nevertheless, it was where they had chosen to allocate a great deal of their risk. However, even after taking into

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Size.” FoundationCenter.org, November 19, 2009. “Foundation Trusts ‘Must Plan for Spending Cuts’.” Health Service Journal, August 11, 2009. Fornari, Fabio. “The Size of the Equity Premium.” European Central Bank (ECB), January 2002. Gilbert, Katie. “He Dare Not Speak Their Name: Just Because This Danish Pension Officer Avoids Saying ‘Hedge Funds’ Doesn

Valuation: Measuring and Managing the Value of Companies

by Tim Koller, McKinsey, Company Inc., Marc Goedhart, David Wessels, Barbara Schwimmer and Franziska Manoury · 16 Aug 2015 · 892pp · 91,000 words

stock markets in 1900, so why do we only look at two, [the UK and 3 E. Dimson, P. Marsh, and M. Staunton, “The Worldwide Equity Premium: A Smaller Puzzle,” in Hand- book of Investments: Equity Risk Premium, ed. R. Mehra (Amsterdam: Elsevier Science, 2007). 4 D. C. Indro and W. Y

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within its normal trading range. 6 Z. Bodie, “Longer Time Horizon ‘Does Not Reduce Risk,”’ Financial Times, January 26, 2002. Marsh, and Staunton, “The Worldwide Equity Premium.” 8 The “yield to maturity” for U.S. government bonds is a good proxy for the expected return, since default expectations are virtually zero. The

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, “Toward an Implied Cost of Capital,” Journal of Accounting Research 39, no. 1 (2001): 135–176. 15 E. F. Fama and K. R. French, “The Equity Premium” (Center for Research in Security Prices Working Paper 522, April 2001). 292 ESTIMATING THE COST OF CAPITAL Once you’ve estimated the real expected return

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earlier, this leads to an expected return between 5.0 percent and 5.5 percent. 5 E. Dimson, P. Marsh, and M. Staunton, “The Worldwide Equity Premium: A Smaller Puzzle,” in Hand- book of Investments: Equity Risk Premium, ed. R. Mehra (Amsterdam: Elsevier Science, 2007). Index A Accelerated depreciation, 405 Accounting: changes

Corporate Finance: Theory and Practice

by Pierre Vernimmen, Pascal Quiry, Maurizio Dallocchio, Yann le Fur and Antonio Salvi · 16 Oct 2017 · 1,544pp · 391,691 words

, The Triumph of the Optimists: 101 Years of Investment Returns, Princeton University Press, 2002. F. Fama, K. French, The equity premium, Journal of Finance, 57(2), 637–659, April 2002. P. Fernandez, The equity premium in 88 countries in 2014: A survey with 8228 answers, Working Paper, June 2014. P. Fernandez, J. Del Campo

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Porta, F. Lopez de Silanes, A. Shleifer, R. Vishny, Law and finance, Journal of Political Economy, 106(6), 1113–1155, December 1998. R. Mehra, The equity premium: Why is it a puzzle?, Financial Analysts Journal, 59(1), 54–69, January–February 2003. On chaos theory: E. Peters, Chaos and Order in Capital

Capital Ideas Evolving

by Peter L. Bernstein · 3 May 2007

and half in fixed-income can expect positive returns in the long run, but need to be realistic. Litterman’s group estimates the long-run equity premium at about 3 to 4 percentage points above bonds, although many economists currently expect less than that. This 50–50 portfolio, then, would create a

All About Asset Allocation, Second Edition

by Richard Ferri · 11 Jul 2010

long-term equity risk premium going forward is about 3 percent annualized over long-term corporate bonds. I’ll take a conservative view on the equity premium over corporate bonds and give it a 2 percent annualized expectation. U.S. equity expectation ⫽ expected long-term corporate bonds ⫹ equity risk premium There are