Is the Equity Premium Getting Smaller?
June 24, 2014
by Michael Edesess
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Since its founding by Will Thomson and Chip Russell in June 2016, the Massif Capital Real Asset Strategy has outperformed all of its real asset benchmarks. Since its inception, the long/short equity fund has returned 9% per annum net, compared to 6% for the Bloomberg Commodity Index, 3% for the 3 MSCI USA Infrastructure index Read More
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Ronald Reagan said that an economist is someone who, when he sees something work in practice, wonders if it can work in theory. This observation fits no topic in economics more snugly than the equity risk premium (ERP). In 1985, economists Rajnish Mehra and now-Nobel laureate Edward C. Prescott noted that from 1889 to 1978, the equity return in excess of the return on relatively riskless securities was more than 6%. They wondered if this could be true in theory. In their 1985 Journal of Monetary Economics paper “The Equity Premium: A Puzzle,” they concluded that no, it could not be true in theory. In fact, they decided, the largest possible premium in theory could be no more than 0.35%, less than a tenth of the observed amount.
Lest the reader think this was a less-than-serious paper on the fringe of economics, think again. A check of the paper on Google scholar finds that it has been cited in other academic works more than 5,000 times. Since Mehra and Prescott’s 1985 paper, the ERP puzzle has been the subject of a plethora of academic studies trying to explain it.
It is understandable that this would be a hot topic. We need an estimate of the expected future return on equity investments — for