Financial Strategy, Second Edition

CASE STUDY 1

Global Evidence on the Equity Risk Premium

Elroy Dimson, Paul Marsh and Mike Staunton

Today, investors have more cause than ever to ask what returns they can expect from equities, and what the future risk-reward tradeoff is likely to be. Corporate managers, too, need to know what returns their shareholders require for projects of differing risk. And regulators have to know the cost of equity capital in order to set “fair” rates of return for regulated industries. In fact, the magnitude of the equity risk premium – the incremental return that shareholders require to hold risky equities rather than risk-free securities – is one of the most important issues in corporate finance. It drives future equity returns and is a key determinant of the cost of capital.

This article sheds light on the equity risk premium by addressing two fundamental questions: How big has the equity risk premium been historically? And what can we expect for the future? To answer these questions, we need to look at long periods of capital market history, and to extend our horizons beyond just the United States. We start by examining equity returns in 16 different countries over the 103-year period from 1900 to 2002.

THE NEED FOR A LONG-RUN PERSPECTIVE

The dangers of focusing just on recent stock market history are easily demonstrated. Over the last decade of the 20th century, U.S. equity investors achieved a total return (capital gain plus reinvested dividends) of 17.6% per annum, thus increasing ...