Blog - Investing Notes

June 30, 2008 - Equity Risk Premium Book Learning

What do leading textbooks have to say about the excess return you got, should expect, should require or should infer from the market for taking the risk of owning stocks? In his June 2008 paper entitled "The Equity Premium in 100 Textbooks", Pablo Fernández reviews definitions and values of the equity risk premium offered in 100 finance and valuation textbooks published from 1979 to 2008. Based on this review, he finds that:

• Estimates of the equity risk premium range from 3% to 10% (see the figure below), with some books presenting different values on different pages.
• Confusion arises from failure to distinguish among:
  • Historical equity premium - the historical differential return of the stock market over treasury instruments.
  • Expected equity premium - the expected differential return of the stock market over treasury instruments.
  • Required equity premium - the incremental return of a diversified portfolio (the market) over the risk-free rate (return of treasury instruments) required by an investor.
  • Implied equity premium - the equity premium that arises from assuming that the market price is correct.

The following chart, taken from the paper, shows estimates for the required equity premium from 100 finance and valuation textbooks according to year of publication for 1978-2008. The data show fairly wide dispersion for any given year and suggest a slight downward trend. The average is 6.6%.

In summary, while mid-single digits may be a reasonable rough estimate for the equity risk premium, there is not a generally accepted value for it or method of estimating it.

For related research, see Blog Synthesis: The Equity Risk Premium. See especially the closely related blog entry of 10/2/06.