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The Market Risk Premium

The Market Risk Premium

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market risk premium
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Research RoundtableThe Equity Premium
By: IVO WELCHYale School of ManagementYale UniversityEmailIvo.welch@yale.eduPostal: Yale UniversityYale School of Management46 Hillhouse Ave.New Haven, CT 06520Phone: (203) 436-0777Fax: (203) 436-0779Organized by PETER TUFANOHarvard Business SchoolHarvard UniversityDiscussantsPETER BOSSAERTS, California Institute of TechnologyJOHN COCHRANE, University of Chicago, Graduate School of BusinessGENE FAMA, University of Chicago, Graduate School of BusinessWILL GOETZMANN, Yale University, School of ManagementROBERT S. HARRIS, Darden Graduate School of Business, University of VirginiaJOHN HEATON, Northwestern University, Kellogg Graduate School of ManagementROGER IBBOTSON, Yale University, School of ManagementMICHAEL J. MAUBOUSSIN, Chief U.S. Investment Strategist - Credit Suisse First Boston andAdjunct Professor - Finance and Economics -Columbia Business SchoolANDRE F. PEROLD, Harvard University, Harvard Business SchoolJAY RITTER, University of Florida, Warrington College of BusinessROBERT WHITELAW, New York University, Stern School of BusinessDiscussion board available at:
Document: Available from SSRN Electronic Paper Collection: 
I. A BRIEF INTRODUCTION TO THE EQUITY PREMIUMLoosely speaking, the equity premium is the difference between the return on risky stocks andreturn on safe bonds. It is the prime input both in the CAPM (the model used by mostpractitioners in computing an appropriate hurdle rate), and in asset allocation decisions (thechoice of whether an investor should hold stocks or bonds).Unfortunately, there is no universally accepted definition of the equity premium. In particular, onecan compute equity premia using different stock market indices, different bonds (either long-termor short-term), different methods of compounding or cumulating returns over time, and differenthistorical time periods. Such computational differences can lead to valid historical equitypremium quotations ranging from 4.3% per year up to about 9.4% per year, depending also onthe time period quoted (e.g., Welch [2000]). It is important for a user of equity premium estimatesto be clear about which definition is used and why it is the appropriate definition for the particularpurpose it is used for.There are three inter-related questions of primary interest to researchers:[1] Why has the historical equity premium been so high?[2] What is a good forward-looking prediction for the equity premium for the long run?[3] Can one use other variables, such as dividend yields, to come up with a good forecast of theequity premium, at least over a 1-5 year period?As first pointed out by Mehra and Prescott [1985], a return differential of, say, 8% per year isenormous especially over a long enough horizon. Ibbotson and Associates, the "gold-standard"provider of historical equity premium data, show that an investment of $1 in 1925 would be worth$5,116 by 1998, whereas an investment in treasury bills would only be worth $15. (And it is wellknown that treasury bill returns generally suffer higher taxes than capital gains!)The profession falls into three loosely defined camps with respect to why equity premia havebeen so high and whether they will continue to be high. The first camp argues that these highequity premia were necessary to induce investors to participate in the stock market (e.g., Benartziand Thaler [1995], Campbell and Cochrane [1999]). This argument implies an equity premium(possibly) as high in the future as in the past. The second camp argues that the expected returnsnecessary to entice investors have fallen in the last few years. This means, stocks can trade formuch higher prices today, which itself is both responsible for the recent stock marketappreciation, and for the expectation of much lower returns in the future (e.g., Heaton and Lucas[1999]). Closely related are arguments that historical equity premia are mismeasured, and notindicative of ex-ante equity premium expectations (e.g., Goetzmann and Jorion [1999], Siegel[1999]). The third camp argues that the stock market has gone crazy and we are all in a bubbleright now. Again, this implies much lower future returns in the future. In contrast to the secondcamp, this camp would be less surprised by a crash or crash-like rapid drop in the stock-market.Although few academics have published this view (except Shiller [2000])---not necessarilybecause they do not dare, but because it is difficult to bring unambiguous evidence to bear onthis matter---many seem to individually subscribe to it. [Footnote: This issue is closely connectedto the question of whether Internet stocks are right now overvalued. Once willing to concede thatinternet stocks are overvalued, it is not a far step to concede that it is possible that the stockmarket as a whole is overvalued, too.]One can also bring additional evidence to bear on the second question without taking a stance onthe first question: There are a number of publicly accessible forecasts from investors, academics,corporations. (Welch [2000]). Typically, investors seem to expect higher equity premia,academics seem to expect equal (or just slightly lower) equity premia, and corporations and
consulting firms seem to expect lower equity premia than those realized in the past. In sum,these forecasts run counter to the view that equity premia have recently been so high, becauseeveryone expects them to be lower in the near future. Finally, a new set of working papers areattempting to attribute "plausible" equity premia based on long-term forecasts of real growth (e.g.,Diamond [2000], Welch [1998]).The third question is equally tricky as the first two questions. There is universal consensus thatthe equity premium cannot be easily predicted over shorter horizons, such as one month; andthat even if the equity premium can be predicted over a longer horizon (e.g., over a 30-yearforecast), we do not have enough historical data to run regressions to validate 30-yearforecasting claims.The variable most often mentioned as a possible predictor of equity premia is the prior-yeardividend-yield. This predictability was first explored in a rigorous manner by the seminal papersof Campbell and Shiller [1988], Fama and French [1988], and Blanchard [1993], which came tothe conclusion that dividend-yields do seem to have predictive ability. In a simple regressionpredicting equity premia one-year ahead with dividend-yields, the dividend yield shows greatstatistical significance. However, a long line of subsequent research has pointed to variousstatistical issues in this early work. Furthermore, most such models predict one-year-aheadforecasts of negative equity premia as of the year 2000---not a sensible prediction. Yet, even ifthere is disagreement of whether documented forecasting ability of dividend yields was real, thereis little disagreement that this predictive ability has disappeared in the 1990s (Goyal-Welch[2000]).Where does this leave us? The equity premium is not only the single most important number offinance, but estimating it is also our most perplexing problem. If the profession fails to makeprogress in understanding the process driving the equity premium, progress on many of the mostimportant problems in finance---proper asset allocation and hurdle rates--are likely to be phyrricvictories only.II. SELECTED BIBLIOGRAPHYBenartzi, Shlomo and Richard H. Thaler. "Myopic L Aversion And The Equity Premium Puzzle,"Quarterly Journal of Economics, 1995, v110(1), 73-92.Blanchard, Olivier J. "Movements In The Equity Premium," Brookings Papers, 1993, v24(2), 75-118.Campbell, John Y. and John H. Cochrane. "By Force Of Habit: A Consumption-BasedExplanation Of Aggregate Stock Market Behavior," Journal of Political Economy, 1999,v107(2,Apr), 205-251.Campbell, John Y. and Robert J. Shiller. "The Dividend-Price Ratio And Expectations Of FutureDividends And Discount Factors," Review of Financial Studies, 1988, v1(3), 195-228.Fama, Eugene F. and Kenneth R. French. "Dividend Yields And Expected Stock Returns,"Journal of Financial Economics, 1988, v22(1), 3-26.Jorion, Philippe and William N. Goetzmann. "Global Stock Markets In The Twentieth Century,"Journal of Finance, 1999, v54(3,Jun), 953-980.Goyal, Amit, and Ivo Welch. "Predicting the Equity Premium." UCLA/Yale Working Paper.http://welch.som.yale.edu/ 

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