Honing in on the Prospective U.S. Equity Risk Premium

What is the latest from academia regarding the prospective equity risk premium? In their November 2006 paper entitled “Estimating the Ex Ante Equity Premium”, Glen Donaldson, Mark Kamstra and Lisa Kramer apply new simulation techniques across ten distinct models to calculate what they claim “is by far the most precise equity premium estimate that has been reported in the literature to date.” Using U.S. dividend growth rates, interest rates, Sharpe ratios, price-dividend ratios, return volatilities and the historical equity premium for 1952-2004 to calibrate their simulations, they conclude that:

• A low dividend yield, high historical equity risk premium, high return volatility and high Sharpe ratio over the last five decades are jointly informative regarding the prospective equity risk premium.
• The prospective U.S. equity risk premium is 3.5% +/- 0.5%.

In summary, investors expect annual equity returns of 3-4% over the risk-free rate in coming years.

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