The Vanishing Equity Risk Premium

Jahnke, William
May 1999
Journal of Financial Planning;May99, Vol. 12 Issue 5, p32
Academic Journal
This article focuses on the equity risk premium in the U.S. The spread in the expected return between equities and bonds is often referred to as the equity risk premium. According to Ibbotson Associates, stocks have returned 11 percent a year since 1926, compounded annually, and bonds have returned 5 percent. Accordingly, the historical equity risk premium is around six percent. There is no direct method for determining the expected equity risk premium. One method employed is to measure the historical return spread between stocks and bonds and argue that the historical spread in returns is a good proxy for the expected equity risk premium. Many proponents of this approach argue that the historical record back to 1926 provides as reasonable a measure of the expected risk premium as is available. But is it safe to assume that the historical spread in returns between stocks and bonds for the last 70 years is a good estimate of today's expected equity risk premium. There is a major problem with the rationale that it is. It is not safe to assume that investors got what they expected, even over a period of 70 years. Investors may have expected more or less than they received. For some extended time periods, they probably got a lot more than they expected, while at other times a lot less. To think that, over 70 years, it averaged out is a bold assumption.


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