Sources of Return
Roger Ibbotson has proposed several building blocks methods that decompose observed stock market returns (for a summary, see Ibbotson 2001). These models begin with an identity and then decompose this relationship into equivalent measures. The basic identity states that nominal stock returns are the product of inflation, the real risk-free rate (on long-term Treasuries) and the equity risk premium:
In the analysis that follows, we will assume that inflation is measured as the year-over-year percentage change in the consumer price index and that the risk-free rate is the nominal yield on the 10-year Treasury. The equity risk premium is defined as follows:
and where the real risk-free rate is defined by:
Substituting and into the first equation establishes the identity.
Using Shiller's annual data spanning 1871 to 2009, I estimate the average long-term return on the 10-year nominal Treasury to be 4.66 percent and a 2.26 percent average inflation rate. ...