2008-01: The U.S. Equity Return Premium: Past, Present and Future

For more than a century, diversified long­horizon investors in America’s stock market have invariably received much higher returns than investors in bonds: a return gap averaging some six percent per year that Rajnish Mehra and Edward Prescott (1985) labeled the “equity premium puzzle.” The existence of this equity return premium has been known for generations: more than eighty years ago financial analyst Edgar L. Smith (1924) publicized the fact that long­horizon investors in diversified equities got a very good deal relative to investors in debt: consistently higher long­run average returns with less risk. It was true, Smith wrote three generations ago, that each individual company’s stock was very risky: “subject to the temporary hazard of hard times, and [to the hazard of] a radical change in the arts or of poor corporate management.” But these risks could be managed via diversification across stocks: “effectively eliminated through the application of the same principles which make the writing of fire and life insurance policies profitable.”