Views of Financial Economists on the Equity Premium and on Professional Controversies

Abstract

The equity premium is perhaps the single most important number in financial economics: the rate by which risky stocks are expected to outperform safe fixed-income investments, such as bonds or bills. It is the main input both in asset allocation decisions—how much of one’s portfolio an investor should put into stocks versus bonds—and in the capital asset pricing model (CAPM)—the model used by most practitioners in computing an appropriate hurdle rate for accepting investment projects. The academic finance profession has been teaching asset allocation and CAPM budgeting for many years. But oddly, it has been relatively quiet in recommending an appropriate ‘‘standard’’ for the equity premium, the key input to these models. This is unfortunate, in that without a good estimate of the equity premium, the mainstream theories are really quite useless from a practical perspective. The main reason for the scarcity of good justifications and recommendations for a ‘‘good practical estimate’’ is, of course, that neither do financial economists know what the correct equity premium is nor is there