RelativeResourceManager - FINANCIAL ANALYSTS JOURNAL"...

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FINANCIAL ANALYSTS JOURNAL" Perspectives on the Equity Risk Premium Jeremy J. Siegel The equity risk premium, or the difference between the expected returns on stocks and on risk-free assets, has commanded the atten- tion of both professional economists and investment practitioners 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 "equity premium" 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 critical not only for asset allocation but also for wealth projections for 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? Academic interest in the equity premium surged after Mehra and Prescott published a seminal article in 1985 titled "The Equity Pre- mium: A Puzzle." By examining the behavior of the stock market and aggregate consumption, they showed that the equity risk premium, under the usual assumptions about investor behavior toward risk, should be much lower than had been calculated from the historical data. Indeed, Mehra and Prescott stated that the equity premium in the U.S. markets should be, at most, 0.35 percent instead of the approx- imately 6 percent premium computed from data going back to 1872. The Mehra-Prescott research raised the following question: Have investors been demanding—and receiving—"too high" a return for holding stocks based on the fundamental uncertainty in the economy, or are the models that economists use to describe investor behavior fundamentally flawed? If the returns have been too high, then analysts can justify increased asset allocation to equities and reduced allocation to bonds; if the models are flawed, economists need to develop new models to describe investor behavior. My discussion of the equity risk premium will be divided into three parts: (1) a summary of the data used to calculate the equity premium and discussion of potential biases in the historical data, (2) 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. Historical Returns on Stocks and Bonds In this section, I present historical asset returns since 1802, define the equity premium, and discuss biases in the historical data that affect future estimates of the equity premium. The equity risk premium determines asset allocations, projections of wealth, and the cost of capital, butwe do not have a simple model that explains the premium. ]eremy J. Siegel is the Russell E. Palmer Professor of Finance at the Wharton
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This note was uploaded on 01/18/2011 for the course FIN Fin511 taught by Professor Chen,w during the Spring '10 term at University of Illinois, Urbana Champaign.

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RelativeResourceManager - FINANCIAL ANALYSTS JOURNAL"...

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