The worldwide equity primium a smaller puzzle
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The worldwide equity primium a smaller puzzle
Comments invitedTHE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLEElroy Dinison. Paul Marsh, and Mike Staunton’London Business SchoolRevised 7 Apiil 2006A The worldwide equity primium a smaller puzzle Abstract: We use a new database of long-run stock, bond. bill, inflation, and currency returns to estimate the equity risk premium for 17 countries and a world index over a 106-year interval. Taking U.S. Treasury bills (government bonds) as the risk-free asset, the annualised equity premium for the The worldwide equity primium a smaller puzzle world index was 4.7% (4.0%). We report the historical equity premium for each market in local currency and US dollars, and decompose the premium intoThe worldwide equity primium a smaller puzzle
dividend growth, multiple expansion, the dividend yield, and changes in the real exchange rate. We infer that investors expect a premium on the world Comments invitedTHE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLEElroy Dinison. Paul Marsh, and Mike Staunton’London Business SchoolRevised 7 Apiil 2006A The worldwide equity primium a smaller puzzle ds: Equity risk premium; long run returns, survivor bias; financial history; stocks, bonds, bills, inflation.London Buainea* Schoo], Regent* Paik. London NW1 4SA. United Kingdom. Tel: -44 (0)20 7262 5050. Email edimwnglcodonedu, pmaiahậlondon edu, and nmuntonglondonedu We ate gi8tefi.ll to Rajniah M The worldwide equity primium a smaller puzzle ehra and an anonymou* refctcc, participant* at over -40*eminai*. and the 37 individual* who contiibuted the dataset* dewribed in Appendix 2ElectronicThe worldwide equity primium a smaller puzzle
copy of this paper is available at: http.//ssrn.com/abstract=891620THE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLEAbstract: We use a new database of loComments invitedTHE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLEElroy Dinison. Paul Marsh, and Mike Staunton’London Business SchoolRevised 7 Apiil 2006A The worldwide equity primium a smaller puzzle val. Taking U.S. Treasury bills (government bonds) as the risk-free asset, the annualised equit}' premium for die world index was 4.7% (4.0%). We lepoit the historical equity premium for each market in local currency and US dollars, and decompose the premium into dividend growth, multiple expansion, The worldwide equity primium a smaller puzzle the dividend yield, and changes in the real exchange rate. We infer that investors expect a premium on the world index of around 3-3%% on a geometricThe worldwide equity primium a smaller puzzle
mean basis, or approximately 4%-5% on an arithmetic basis.In their seminal paper on the equity premium puzzle. Mehra and Prescott (1985) showed that Comments invitedTHE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLEElroy Dinison. Paul Marsh, and Mike Staunton’London Business SchoolRevised 7 Apiil 2006A The worldwide equity primium a smaller puzzle ls—was much larger than could be justified as a risk premium on the basis of standard theory. Using the accepted neoclassical paradigms of financial economics, combined with estimates of the mean, variance and auto-correlation of annual consumption growth in the U.S. economy and plausible estimates The worldwide equity primium a smaller puzzle of the coefficient of risk aversion and time preference, the}- argued that stocks should provide at most a 0.35% annual risk premium over bills. EvenThe worldwide equity primium a smaller puzzle
by stretching the parameter estimates, they concluded that the premium should be no more than 1% (Mehra and Prescott (2003)). This contrasted starkly Comments invitedTHE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLEElroy Dinison. Paul Marsh, and Mike Staunton’London Business SchoolRevised 7 Apiil 2006A The worldwide equity primium a smaller puzzle than the sign, of the risk premium. Iionically, since Melua and Prescott wrote theii paper, this puzzle has grown yet more quantitatively puzzling. Over the 27 years from the end of the period they examined to the date of completing this contribution, namely over 1979-2005. the mean annual U.S. equi The worldwide equity primium a smaller puzzle ty premium relative to bills using Mehra-Prescott’s definition and data sotuces was 8.1%.Logically, there are two possible resolutions to the puzzle eThe worldwide equity primium a smaller puzzle
ither the standard models are wrong, or else the historical premium IS misleading and we should expect a lower premium 111 the future. Over the last tComments invitedTHE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLEElroy Dinison. Paul Marsh, and Mike Staunton’London Business SchoolRevised 7 Apiil 2006A The worldwide equity primium a smaller puzzle alternative assumptions about preferences, including risk aversion, state separability, leisure, habit formation and precautionary saving: incomplete markets and lunnsurable income shocks: modified probability distributions to admit rare, disastrous events, market imperfections, such as bonowing con The worldwide equity primium a smaller puzzle straints and transactions costs: models of hunted participation of consumers 111 the stock market, and behavioural explanations There are several exceThe worldwide equity primium a smaller puzzle
llent surveys of this work, including Kocherlakota (1996). Cochrane (1997). Melira and Prescott (2003). and most recently. Melua and Prescon (2006).WhComments invitedTHE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLEElroy Dinison. Paul Marsh, and Mike Staunton’London Business SchoolRevised 7 Apiil 2006A The worldwide equity primium a smaller puzzle ns to the standard models" and "every quantitatively successful current story...still requires astonishingly high risk aversion”. This leads us back to the second possible resolution to the puzzle, namely, that the historical premium may be misleading. Perhaps U.S. equity investors simply enjoyed go The worldwide equity primium a smaller puzzle od fortune and the twentieth century for them represented the “triumph of the optimists" (Dimson. Marsh, and Staunton (2002)). As Cochrane (1997) putsThe worldwide equity primium a smaller puzzle
It, maybe It was simply “100 years of good hick"—the opposite of the old joke about Soviet agr iculture being the result of “100 years of bad luck."1Comments invitedTHE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLEElroy Dinison. Paul Marsh, and Mike Staunton’London Business SchoolRevised 7 Apiil 2006A The worldwide equity primium a smaller puzzle making the historical data even more misleading. To illustrate this, consider the parallel with selection bias in the choice of stocks, and the task facing a researcher who wished to estimate the required risk premium and expected return on the common stock of Microsoft. It would be foolish to extra The worldwide equity primium a smaller puzzle polate from Microsoft's stellar past performance. Its success and survival makes it nontypical of companies as a whole. Moreover, ill Ils core businesThe worldwide equity primium a smaller puzzle
s Microsoft has a market share above 50%. Since, by definition, no competitor can equal this accomplishment, we should not extrapolate expected returnComments invitedTHE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLEElroy Dinison. Paul Marsh, and Mike Staunton’London Business SchoolRevised 7 Apiil 2006A The worldwide equity primium a smaller puzzle re is ex post selection bias based on past success, liistoiical mean returns will piovide an upward biased estimate of future expected returns. That is one reason why equity premium projections are usually based on the performance of the entile market, including unsuccessful as well as successfill s The worldwide equity primium a smaller puzzle tocks.l or similar reasons, we should also be uncomfortable about extrapolating from a stock market that has survived and been successfill, and gainedThe worldwide equity primium a smaller puzzle
a marker share of above 50%. Organized trading 111 marketable securities began m Amsterdam ui 1602 and London in 1698. but did not commence in New YoComments invitedTHE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLEElroy Dinison. Paul Marsh, and Mike Staunton’London Business SchoolRevised 7 Apiil 2006A The worldwide equity primium a smaller puzzle isen from zero to around 50% (see Dimson, Marsh, and Staunton (2004)). This reflects the superior performance of the U.S. economy, as evidenced by a large volume of initial public offerings (IPOs) and seasoned equity offerings (SEOs) that enlarged rhe U.S. equity marker, and the substantial returns The worldwide equity primium a smaller puzzle from U.S. common stocks alter they liad gained a listing. No other market can rival tills long-term accomplishment.Melua and Prescotts initial focus oThe worldwide equity primium a smaller puzzle
n the United States and the ready availability of U.S. data has ensured that much of the subsequent research prompted by their papei has investigated Comments invitedTHE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLEElroy Dinison. Paul Marsh, and Mike Staunton’London Business SchoolRevised 7 Apiil 2006A The worldwide equity primium a smaller puzzle that has been observed historically ill the United States, and seeks to show why the Mehra-Prescott observations are not (quite so much of) a puzzle. Some empirical work has looked beyond the United States, including Jorioii and Goetzmann (1999) and Mehra and Prescott (2003) However, researchers ha The worldwide equity primium a smaller puzzle ve hitherto been hampered by the paucity of long-nm equity returns data for other countries. Most research seeking to resolve the cquit} premium puzzlThe worldwide equity primium a smaller puzzle
e has thus focused on empirical evidence for die United States. Tn emphasizing the U.S. a country that must be a relative outlier this body of work maComments invitedTHE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLEElroy Dinison. Paul Marsh, and Mike Staunton’London Business SchoolRevised 7 Apiil 2006A The worldwide equity primium a smaller puzzle been non-stationaiy. This could have arisen if over the measurement interval, there have been changes m risk, or the risk altitude of investors, or investors’ diversification opportunities. If. for example, these have caused a reduction in the risk premium, this fall in the discount rate will: Aiuxb The worldwide equity primium a smaller puzzle cr key reason is that equilibrium asset pt-xing theories such as the CAl’M or CCAl’M assign a special role to tile value weighted market portfolio. HoThe worldwide equity primium a smaller puzzle
wever, our argument tor looking beyond the United States is twt dependent on the assumption that the market portfolio ••hoiild necewarily be the worldGọi ngay
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