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

For more than a century, diversified long-horizon investments in America’s stock market have consistently received much higher returns than investors in bonds: a return gap averaging 6 percent per year. Rajnish Mehra and Edward Prescott (1985) name this pattern the “equity premium puzzle.” An enormous amount of creative and ingenious work by a great many economists has gone into seeking explanations for the equity premium return puzzle, but so far without a fully satisfactory answer. The existence of this equity return premium has been known for generations. More than 80 years ago, financial analyst Edgar L. Smith (1924) publicized the fact that long-horizon investors in diversified equities got a very good deal relative to investors in debt: consistently higher long-run average returns with no more 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, or as Smith wrote, “effectively eliminated through the application of the same principles which make the writing of fire and life insurance policies profitable.” Edgar L. Smith was right for his day. Common stocks had consistently been attractive as long-term investments. The Cowles index of American stock prices with which Shiller extends the Standard and Poor’s data, deflated by consumer prices,