History and the Equity Risk Premium

Abstract The equity premium puzzle posed in Mehra and Prescott (1985) was, in part, motivated by historical evidence on the return of U.S. stocks in excess of the riskless rate. Much of our own research has focused on estimating the equity risk premium using long-term historical data, and examining how historical accident may relate to the classic puzzle. While the equity premium is a fascinating topic for scholarship, it is also one of the most important economic topics in modern finance. The equity risk premium is widely used to forecast the growth of investment portfolios over the long term. It is also used as an input to the cost of capital in project choice, and employed as a factor in the expected rate of return to stocks. Given its prevalence in practice and its importance to academic thought, it is interesting to discover that the calculation of the equity risk premium is a fairly new phenomenon. Reliable data to estimate the historical premium of stocks over bonds were only collected in the mid-20th century, and precise econometric estimates of the equity premium only came after the development of the theory that uses it as a central input—the Capital Asset Pricing Model, or CAPM.