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 the July 2011 version of his paper entitled “The Equity Premium in 150 Textbooks”, Pablo Fernandez reviews definitions and values of the equity risk premium offered in 150 finance and valuation textbooks published from 1979 to 2009. Based on this review, he finds that:
- Estimates of the equity risk premium range from 3% to 10%, 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 five-year moving average of estimates of the required equity risk premium declines from 8.4% in 1990 to 5.7% in 2008 and 2009 (see charts below).
The following chart, taken from the paper, shows estimates for the required equity premium across all 150 finance and valuation textbooks according to year of publication for 1978-2009. The data show fairly wide dispersion for any given year and have a downward trend over time. The average for all 150 textbooks is 6.5%.
The next chart, also from the paper, plots the five-year moving average of the required equity premium from the preceding data. The current value is 5.7%.
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.
