Blog - Investing Notes

April 26, 2006 - The Worldwide Equity Risk Premium

In the April 2006 version of their paper entitled "The Worldwide Equity Premium: A Smaller Puzzle", Elroy Dimson, Paul Marsh, and Mike Staunton estimate the equity risk premium for 17 countries and a world index over a period of 106 years. They report the historical equity premium for each country in both local currency and U.S. dollars, and they decompose the premium into dividend growth, multiple expansion, the dividend yield and changes in the real exchange rate. Using a new database of stock, bond, bill, inflation, and currency returns for the period 1900-2005, they conclude that:

• The annualized historical worldwide equity premium over U.S. Treasury bills (bonds) for 1900-2005 is 4.7% (4.0%). The U.S. moderately outperforms this worldwide result.
• Equity returns and premiums in all 17 countries vary considerably on even a decade-by-decade basis (see data for the U.S. below). Returns show high kurtosis (fat tails) but almost no serial correlation.
• World wars were less damaging to equity investors than were peacetime bear markets.
• In all 17 countries, dividend yields constitute most (90%, on average) of the equity returns and premiums.
• The prospective worldwide equity risk premium is about 3-3.5% (4.5-5%) on a geometric (arithmetic) mean basis.

The authors also provide a brief history of the equity premium, a description of their 106-year worldwide financial markets database and a discussion on the methodology of forecasting the prospective equity risk premium.

The following chart, taken from the paper, depicts historical equity premiums compared to U.S. Treasury bills (T-bills) for all years and for rolling 10-year periods during 1900-2005. It demonstrates the unevenness of the relative performance of stocks and T-bills, and therefore the importance of very long investment horizons for purely statistical diversified (broad index or "dumb") investing.

The next chart, also from the paper, shows the annualized (geometric mean) historical equity premiums relative to both bills and bonds over 1900–2005 for 17 countries, the worldwide index and the worldwide index excluding the U.S. It shows that equities outperformed both bills and bonds in all 17 countries, but that some countries have offered better environments for equities than others. (For Germany, results exclude 1922-1923, during which hyperinflation destroyed the value of local bills and bonds.)

The following table, also from the paper, decomposes the historical equity premiums (calculated from the standpoint of U.S. investors) into their component parts. It shows that, over the very long run, dividend payments produce most (68% for the U.S. and 74% for the worldwide index) of the real returns from equities. The contributions from the dividend growth rate, expansion of the price/dividend ratio (P/D) and currency adjustments are relatively small. Adjusting the historical dividend yield for the impact of stock repurchases boosts the U.S. historical dividend yield to approximately 4.7%. This adjustment is less important in other countries. (For Germany, results again exclude 1922-1923.)

In summary, investors should expect an equity premium in mid-single digits across markets in all countries over the very long term.

For other research on the equity risk premium, see Blog Synthesis: The Equity Risk Premium.