J Return on a Risk-free Security Since there were no Treasury bills at the time,researchers have used the data set con- structed by Siegel(1998)for this period,using highly rated securities with an adjustment for the default premium.It is interesting to observe,as mentioned earlier,that based on this data set the equity premium for the period 1802-1862 was zero.We conjecture that this may be due to the fact that since most financing in the first half of the nineteenth century was done through debt, the distinction between debt and equity securities was not very clear-cut. Sub-period 1871-1926 Equity Return Data Shiller(1989)is the definitive source for the equity return data for this period.His data is based on the work of Cowles(1939),which covers the period 1871-1938.Cowles used a value- weighted portfolio for his index,which consisted of 12 stocks'in 1871 and ended with 351 in 1938.He included all stocks listed on the New York Stock Exchange,whose prices were re- ported in the Commercial and Financial Chronicle.From 1918 onward he used the Standard and Poor's(S&P)industrial portfolios.Cowles reported dividends,so that,unlike the earlier indexes for the period 1802-1871,a total return calculation was possible. Return on a Risk Free Security There is no definitive source for the short-term risk-free rate in the period before 1920, when Treasury certificates were first issued.In our 1985 study,we used short-term commercial 6 The first actively traded stock was floated in the U.S in 1791 and by 1801 there were over 300 corporations,although less than 10 were actively traded.Siegel (1998)). It was only from Feb.16,1885,that Dow Jones began reporting an index,initially composed of 12 stocks.The S&P index dates back to 1928,though for the period 1928-1957 it consisted of 90 stocks.The S&P 500 debuted in March 1957
5 Return on a Risk-free Security Since there were no Treasury bills at the time, researchers have used the data set constructed by Siegel (1998) for this period, using highly rated securities with an adjustment for the default premium. It is interesting to observe, as mentioned earlier, that based on this data set the equity premium for the period 1802–1862 was zero. We conjecture that this may be due to the fact that since most financing in the first half of the nineteenth century was done through debt, the distinction between debt and equity securities was not very clear-cut.6 Sub-period 1871–1926 Equity Return Data Shiller (1989) is the definitive source for the equity return data for this period. His data is based on the work of Cowles (1939), which covers the period 1871–1938. Cowles used a valueweighted portfolio for his index, which consisted of 12 stocks7 in 1871 and ended with 351 in 1938. He included all stocks listed on the New York Stock Exchange, whose prices were reported in the Commercial and Financial Chronicle. From 1918 onward he used the Standard and Poor’s (S&P) industrial portfolios. Cowles reported dividends, so that, unlike the earlier indexes for the period 1802–1871, a total return calculation was possible. Return on a Risk Free Security There is no definitive source for the short-term risk-free rate in the period before 1920, when Treasury certificates were first issued. In our 1985 study, we used short-term commercial 6 The first actively traded stock was floated in the U.S in 1791 and by 1801 there were over 300 corporations, although less than 10 were actively traded. ( Siegel (1998)). 7 It was only from Feb. 16, 1885, that Dow Jones began reporting an index, initially composed of 12 stocks. The S&P index dates back to 1928, though for the period 1928–1957 it consisted of 90 stocks. The S&P 500 debuted in March 1957
6 paper as a proxy for a riskless short-term security prior to 1920 and Treasury certificates from 1920-1930.Our data prior to 1920,was taken from Homer(1963).Most researchers have either used our data set or Siegel's. Sub-period 1926-present Equity Return Data This period is the"Golden Age"in regards to accurate financial data.The NYSE data- base at the Center for Research in Security Prices(CRSP)was initiated in 1926 and provides re- searchers with high quality equity return data.The Ibbotson Associates Yearbooks are also a very useful compendium of post-1926 financial data. Return on a Risk-free Security Since the advent of Treasury bills in 1931,short maturity bills have been an excellent proxy for a"real"risk-free security since the innovation in inflation is orthogonal to the path of real GNP growth.Of course,with the advent of Treasury Inflation Protected Securities(TIPS) on January 29,1997,the return on these securities is the real risk-free rate. 1.3 Estimates of the Equity Premium Historical data provides us with a wealth of evidence documenting that for over a cen- tury,stock returns have been considerably higher than those for Treasury-bills.This is illustrated in Table 1,which reports the unconditional estimates for the US equity premium based on the 8 Ibbotson Associates."Stocks,Bonds,Bills and Inflation."2000 Yearbook.Chicago.Ibbotson Associates.2001. See Litterman(1980)who also found that that in post war data the innovation in inflation had a standard deviation of one half of nconditional estimates we use the cntire data set to fomm our estimate.The Mchra-Prescott data sct covers the ong est time period for which both consumption and stock return data is available.The former is necessary to test the implication of consumption based asset pricing models
6 paper as a proxy for a riskless short-term security prior to 1920 and Treasury certificates from 1920–1930. Our data prior to 1920, was taken from Homer (1963). Most researchers have either used our data set or Siegel’s. Sub-period 1926–present Equity Return Data This period is the “Golden Age” in regards to accurate financial data. The NYSE database at the Center for Research in Security Prices (CRSP) was initiated in 1926 and provides researchers with high quality equity return data. The Ibbotson Associates Yearbooks8 are also a very useful compendium of post–1926 financial data. Return on a Risk-free Security Since the advent of Treasury bills in 1931, short maturity bills have been an excellent proxy for a “real” risk-free security since the innovation in inflation is orthogonal to the path of real GNP growth.9 Of course, with the advent of Treasury Inflation Protected Securities (TIPS) on January 29, 1997, the return on these securities is the real risk-free rate. 1.3 Estimates of the Equity Premium Historical data provides us with a wealth of evidence documenting that for over a century, stock returns have been considerably higher than those for Treasury-bills. This is illustrated in Table 1, which reports the unconditional estimates10 for the US equity premium based on the 8 Ibbotson Associates. “Stocks, Bonds, Bills and Inflation.” 2000 Yearbook. Chicago. Ibbotson Associates. 2001. 9 See Litterman (1980) who also found that that in post war data the innovation in inflation had a standard deviation of one half of one percent. 10 To obtain unconditional estimates we use the entire data set to form our estimate. The Mehra-Prescott data set covers the longest time period for which both consumption and stock return data is available. The former is necessary to test the implication of consumption based asset pricing models
various data sets used in the literature,going back to 1802.The average annual real return,(the inflation adjusted return)on the U.S.stock market over the last 110 years has been about 8.06 percent.Over the same period,the return on a relatively riskless security was a paltry 1.14 per- cent.The difference between these two returns,the"equity premium,"was 6.92 percent. Furthermore,this pattern of excess returns to equity holdings is not unique to the U.S.but is observed in every country with a significant capital market.The U.S.together with the U.K., Japan,Germany and France accounts for more than 85 percent of the capitalized global equity value. The annual return on the British stock market was 5.7 percent over the post war period, an impressive 4.6 percent premium over the average bond return of 1.1 percent.Similar statisti- cal differentials are documented for France,Germany and Japan.Table 2 illustrates the equity premium in the post war period for these countries. Table 1 U.S.Equity Premium Using Different Data Sets Data Set real return on a real return on a relatively equity pre- market index riskless security mium Mean Mean Mean 1802-1998 7.0 2.9 4.1 (Siegel) 1871-199 6.99 1.74 5.75 (Shiller) 1889-2000 8.06 1.14 6.92 (Mehra-Prescott) 1926-2000 8.8 0.4 8.4 (Ibbotson)
7 various data sets used in the literature, going back to 1802. The average annual real return, (the inflation adjusted return) on the U.S. stock market over the last 110 years has been about 8.06 percent. Over the same period, the return on a relatively riskless security was a paltry 1.14 percent. The difference between these two returns, the “equity premium,” was 6.92 percent. Furthermore, this pattern of excess returns to equity holdings is not unique to the U.S. but is observed in every country with a significant capital market. The U.S. together with the U.K., Japan, Germany and France accounts for more than 85 percent of the capitalized global equity value. The annual return on the British stock market was 5.7 percent over the post war period, an impressive 4.6 percent premium over the average bond return of 1.1 percent. Similar statistical differentials are documented for France, Germany and Japan. Table 2 illustrates the equity premium in the post war period for these countries. Table 1 U.S. Equity Premium Using Different Data Sets Data Set % real return on a market index % real return on a relatively riskless security % equity premium Mean Mean Mean 1802-1998 (Siegel) 7.0 2.9 4.1 1871-199 (Shiller) 6.99 1.74 5.75 1889-2000 (Mehra-Prescott) 8.06 1.14 6.92 1926-2000 (Ibbotson) 8.8 0.4 8.4
P Table 2 Equity Premium in Different Countries Country real return real return on a relatively %equity pre- on a market riskless security mium index Mean Mean Mean UK 5.7 1.1 4.6 (1947-1999) Japan 4.7 1.4 3.3 (1970-1999) Germany 9.8 3.2 6.6 (1978-1997 France 9.0 2.7 6.3 (1973-1998) Source:U.K from Siegel (1998),the rest are from Campbell (2001) The dramatic investment implications of this differential rate of return can be seen in Table 3,which maps the capital appreciation of $1 invested in different assets from 1802 to 1997 and from 1926 to 2000. Table3 Terminal value of $1 invested in Stocks and Bonds Investment Period Stocks T-bills Real Nominal Real Nominal 1802-1997 $558,945 $7.470,000 $276 $3,679 1926-2000 $266.47 $2,586.52 $1.71 $16.56 Source:Ibbotson(2001)and Siegel(1998) As Table 3 illustrates,$1 invested in a diversified stock index yields an ending wealth of $558,945 versus a value of $276,in real terms,for $1 invested in a portfolio of T-bills for the period 1802-1997.The corresponding values for the 75-year period,1926-2000,are $266.47 and $1.71.We assume that all payments to the underlying asset,such as dividend payments to
8 Table 2 Equity Premium in Different Countries Country % real return on a market index % real return on a relatively riskless security % equity premium Mean Mean Mean UK (1947-1999) 5.7 1.1 4.6 Japan (1970-1999) 4.7 1.4 3.3 Germany (1978-1997) 9.8 3.2 6.6 France (1973-1998) 9.0 2.7 6.3 Source: U.K from Siegel (1998), the rest are from Campbell (2001) The dramatic investment implications of this differential rate of return can be seen in Table 3, which maps the capital appreciation of $1 invested in different assets from 1802 to 1997 and from 1926 to 2000. Table 3 Terminal value of $1 invested in Stocks and Bonds Investment Period Stocks T-bills Real Nominal Real Nominal 1802-1997 $558,945 $7,470,000 $276 $3,679 1926-2000 $266.47 $2,586.52 $1.71 $16.56 Source: Ibbotson (2001) and Siegel (1998) As Table 3 illustrates, $1 invested in a diversified stock index yields an ending wealth of $558,945 versus a value of $276, in real terms, for $1 invested in a portfolio of T-bills for the period 1802–1997. The corresponding values for the 75-year period, 1926–2000, are $266.47 and $1.71. We assume that all payments to the underlying asset, such as dividend payments to
9 stock and interest payments to bonds are reinvested and that there are no taxes paid. This long-term perspective underscores the remarkable wealth building potential of the equity premium.It should come as no surprise therefore,that the equity premium is of central importance in portfolio allocation decisions,estimates of the cost of capital and is front and cen- ter in the current debate about the advantages of investing Social Security funds in the stock market. In Table 4 we report the premium for some interesting sub-periods:1889-1933,when the United States was on a gold standard;1933-2000,when it was off the gold standard;and 1946-2000,the postwar period.Table 5 presents 30 year moving averages,similar to those re- ported by the US meteorological service to document'normal'temperature. Table4 Equity Premium in Different Sub-Periods Time Period real return real return on a relatively %equity pre- on a market riskless security mium index Mean Mean Mean 1889-1933 7.01 3.09 3.92 19342000 8.76 -0.17 8.93 1946-2000 9.03 0.68 8.36 Source:Mehra and Prescott(1985).Updated by the authors
9 stock and interest payments to bonds are reinvested and that there are no taxes paid. This long-term perspective underscores the remarkable wealth building potential of the equity premium. It should come as no surprise therefore, that the equity premium is of central importance in portfolio allocation decisions, estimates of the cost of capital and is front and center in the current debate about the advantages of investing Social Security funds in the stock market. In Table 4 we report the premium for some interesting sub-periods: 1889–1933, when the United States was on a gold standard; 1933–2000, when it was off the gold standard; and 1946–2000, the postwar period. Table 5 presents 30 year moving averages, similar to those reported by the US meteorological service to document ‘normal’ temperature. Table 4 Equity Premium in Different Sub-Periods Time Period % real return on a market index % real return on a relatively riskless security % equity premium Mean Mean Mean 1889–1933 7.01 3.09 3.92 1934–2000 8.76 -0.17 8.93 1946–2000 9.03 0.68 8.36 Source: Mehra and Prescott (1985). Updated by the authors