Journal of Applied Corporate Finance

S P R I N G 1 9 9 9 V O L U M E 1 2 . 1


Estimating the Equity Risk Premium and Equity Costs:
New Ways of Looking at Old Data
by Laurence Booth,
University of Toronto




100
JOURNAL OF APPLIED CORPORATE FINANCE
ESTIMATING THE EQUITY
RISK PREMIUM AND
EQUITY COSTS:
NEW WAYS OF LOOKING
AT OLD DATA
by Laurence Booth,
University of Toronto
100
BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE
2. R. G Ibbotson and R. A. Sinqufeld, Stocks, Bonds, Bills and Inflation: The
Past (1926-76) and the Future (1977-2000), Financial Analysts Research Founda-
tion, 1977. This is now updated annually by Ibbotson and Associates.
1. The Wealth of Nations, p. 136.
As a result it is impossible to ignore the impact of
investment horizon on the discount rate. It is gener-
ally acknowledged that the risk-free rate depends on
the time period over which the cash flows are being
valued. For example, the 30-day Treasury bill yield
reflects the risk free rate for a 30-day holding period,
but it is not a risk-free rate for an investor with an
investment horizon either longer or shorter than 30
days. Similarly, the 20-year Treasury yield reflects the
risk-free rate for a 20-year investment horizon. An
additional complication for long-term bond yields is
the reinvestment rate risk associated with reinvesting
the intermediate coupons. However, to the extent that
a similar reinvestment rate risk exists for project cash
flows, the long-term Treasury bond yield more closely
matches the investment horizon for typical capital
budgeting and valuation problems than does the
Treasury bill yield. As a result, in practice most equity
discount rate calculations start out with the long-term
Treasury bond yield as the appropriate risk-free rate.
The focus in calculating an equity discount rate
then quickly shifts to adding the appropriate risk
premium to the yield on long treasuries. In practice,
much of this effort focuses on the estimation of the
relevant risk or beta coefficient, with relatively little
time spent on the equity risk premium. Normally the
equity risk premium is taken to be the long-run
average excess return of equities over bonds taken
from the data compiled by Ibbotson and Sinquefeld.
2
For example, this is the common approach taken in
regulatory hearings to determine the equity discount
rate, with either a CAPM risk premium or average
utility risk premium added to the long bond yield.
demand extra profit or return in compensation for
bearing it, is a cornerstone of modern finance.
Further, it was the major factor in the award of the
Nobel prize in economics to William Sharpe and
Harry Markowitz for the development of modern
portfolio theory and the Capital Asset Pricing Model
(CAPM). Their contribution was to show that the risk
premium, or the extra rate of profit in Smiths
terminology, is related to the contribution of a
security to the risk of a diversified portfolio. Ever
since, required rates of profit or discount rates have
predominantly been determined by a three-step
procedure: (1) estimate the appropriate risk free rate;
(2) estimate the equity market, or average, risk
premium; and (3) adjust the equity risk premium for
the particular risk of the security or firm.
For the CAPM, this procedure amounts to
implementing the following equation:
K
j
= R
F
+ (E(R
e
) R
F
) *
j
(1)
where K
j
is the required return or discount rate for
security j, R
F
the risk-free rate, and the equity risk
premium (ERP) is just the difference between the
expected return on the market (E(R
e
)), ie., the
average of all securities, and the risk free rate, and

j
the securitys beta coefficient.
While the CAPM is a single period model,
most problems in finance involve multiple periods.
n The Wealth of Nations Adam Smith
states that The ordinary rate of profit
always rises more or less with the risk.
1
This idea that investors dislike risk, and
I
VOLUME 12 NUMBER 1 SPRING 1999
101
In this paper, I reverse this sequence of events.
Instead of focusing on beta coefficients, I focus
directly on estimating the equity return and then
consider, among other things, whether it makes
sense to estimate this by means of adding a constant
risk premium to the prevailing long Treasury yield.
Critical questions raised by this process are whether
the equity risk premium is stable, and whether the
common practice of adding a premium to the long
Treasury yield is better than just using the average
historic equity return directly and ignoring the
performance of the bond market entirely. I also
consider the question of which equity return should
be used: That is, is it better to estimate an average
nominal equity return and use that as a forecast of
future nominal returns, or should a real return be
estimated and then the current inflation rate be
added?
This paper shows that all of these approaches
are subject to potential bias of one kind or another,
and that there is thus no automatic right answer.
Instead, capital market evidence and knowledge of
economic events should guide the users choice
among these different estimation techniques.
ESTIMATION PRINCIPLES
The main source of data on the equity risk
premium comes from the seminal work of Ibbotson
and Sinqufeld, who have calculated holding period
return data from December 1925 to the present for
common equities, long-term government bonds,
Treasury bills, and the consumer price index. Ibbotson
and Sinquefeld claim that the equity risk premium
over Treasury bills follows a random walk and that,
for this reason, the historic average excess return is
the best forecast of the current equity risk premium.
3
To understand their conclusion, lets adopt their
assumption (an assumption I will question later) that
the equity risk premium is a random walk, as shown
in equation 2, with constant mean and constant,
independent and identically distributed error terms:
4
ERP
t
= +
t
(2)
where ERP
t
, is the actual excess return of equities
(Re,t) over 30-day Treasury bills at time t, which is
equal to the constant equity risk premium () plus
a random error term (
t
). The estimated average
value of equation (2) over T periods can then be
expressed as follows:
AERP = + (
T
t=1

t
)/T (3)
If the error terms are indeed independent and
identically distributed each period, then the average
from T period observations is simply the true equity
risk premium plus the average error term, which with
enough observations will eventually sum to zero. As
a result, with larger and larger time periods we can
be more and more confident that the estimated
average risk premium is equal to the constant
expected risk premium.
Ibbotson and Sinquefeld calculate the simple
average equity risk premium in the above manner
and suggest that this be added to the current 30-day
yield on a Treasury bill to estimate the current equity
discount rate. This suggestion is then dutifully fol-
lowed in almost every introductory finance textbook.
Leaving aside the problem that the 30-day
Treasury bill yield is not a useful risk-free rate for
most problems in finance, the astute reader might
wonder why the average equity market return is not
a better measure of the expected return on the
market? That is, if the return on equity follows the
same process as equation (2), why not estimate the
average equity return directly, rather than by adding
the average excess return to a Treasury bill yield?
The reason given by Ibbotson and Sinquefeld is
that the return from holding Treasury bills does not
follow the above process. Because T-bill yields
fluctuate with monetary policy, they are serially
correlated, and thus have clearly had different aver-
age values at different points in time. Further, if stock
market risk and the market price of risk (risk
aversion) have been constant over time, then the
equity risk premium will have followed a random
walk, and equity returns are generated by the
following process:
R
e,t
= R
30,t
+ +
t
(4)
where R
30,t
is the return on 30 day Treasury bills. A
simple average of equation (4) is then
4. This is a Random Walk 1 as discussed by J. Campbell, A. Lo and A. C.
Mackinlay, The Econometrics of Financial Markets, Princeton, 1997. We will use
the term random walk to mean the above process.
3. For example, Stocks, Bonds, Bills and Inflation 1986 Yearbook, Ibbotson
and Associates, Inc. 1986, p. 71.
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JOURNAL OF APPLIED CORPORATE FINANCE
(
T
t=1
R
e,t
)/T = (
T
t=1
R
30,t
)/T + + (
T
t=1

t
)/T (5)
where the average equity return is equal to the
average T-bill yield plus the equity risk premium plus
the average error term. Even if equation (5) is
summed over very long periods, there is no reason
to believe that the average equity return will equal
the expected return; in fact, it will only do so if the
average T-bill yield is equal to the current T-bill yield.
This imparts what I will call a risk free rate bias to the
equity return estimate. For example, suppose the
average equity return is 10%, composed of an
average T-bill return of 6% and an equity risk
premium of 4%. If during the business cycle T-bill
yields go from 4% to 8%, then the use of the average
10% rate will overestimate equity costs when T-bill
yields are low and underestimate them when they
are high. The problem, of course, is that short-term
T-bill yields are extremely volatile, so that even if the
average T-bill yield over a business cycle is constant,
using equation (5) within a business cycle will cause
serious estimation errors.
Ibbotson and Sinquefelds justification for esti-
mating the equity risk premium and adding it to the
current Treasury Bill yield is correct, provided that
the process driving equity returns is that given in
equation (4). At its core the assumption is that equi-
librium asset prices are determined based on short-
term investment horizons and that the correct risk-
free rate is the return on a 30-day Treasury bill. An
equally plausible argument, however, is that the
correct risk-free rate for the equity market is a one-
year Treasury bond yield, since this is closer to the
implicit investment horizon, and thus the opportu-
nity cost, of the average investor.
5
More to the point,
it is the horizon over which most cash flows are
discounted for valuation purposes. However, even if
Ibbotson and Sinquefelds assumption is correct, the
resulting equity discount rate is not very useful for
valuation purposes, since the correct risk-free rate for
these purposes is closer to the long Treasury yield.
Assume more realistically that the correct risk-
free rate used for valuing equities is unknownand
lets call it Rm for a medium-term rate, but the point
is that we simply do not know what it is. In this case,
equities, long-term bonds, and Treasury bills are all
risky. However, since we are not interested in Trea-
sury bills, lets just consider the returns for equities,
R
e,t
= R
m,t
+ +
t
(6)
and long bonds,
R
l,t
= R
m,t
+ TP
t
+
t
(7)
where the long term bond return is equal not only
to the unknown risk-free rate plus an error term (
t
),
but also a term premium (TP
t
) to capture the fact that
long-term bonds are riskier than short-term bonds.
In this case, the average returns for both equity and
the long bond are subject to the same risk-free rate
problems as in equation (5), where the correct risk-
free rate is the Treasury Bill yield. However, if the
correct risk-free rate is a medium term rate, it is less
susceptible to the volatility due to monetary policy
than is the Treasury Bill rate, and the risk-free rate
bias is reduced.
The equity risk premium measured over long
bonds can then be expressed as follows:
R
e,t
R
l,t
= TP +
t

t
(8)
and the average equity risk premium estimated over
T periods is
AERP =
T
t=1
TP
t
/T +
T
t=1
(
t

t
)/T (9)
Equation 9 will produce an estimate of the risk
premium over the true risk-free rate that is biased
low, since long bonds are themselves risky and
hence command a term premium.
The implications from equations (6), (7), and (9)
are several. First, if the true risk-free rate is of a longer
term than the 30-day return on a 90-day T-bill, then
the risk free rate bias is reduced. In fact, there may
be no reason for using the risk premium approach
at all, depending on the behavior of medium-term
yields. Moreover, since the 30-day T-bill is also risky
for a longer investment horizon due to reinvestment
rate risk, there is nothing special about the statistical
properties of an equity risk premium estimated over
Treasury bills.
Second, an equity risk premium estimated over
long bonds is composed of three distinct compo-
nents: the true equity risk premium over the un-
known risk-free rate; the average term premium
attached to long term bonds; and the residual
5. The obsession with monthly data in finance is driven more by statistical
needs for enough current observations, than any fundamental economic reasons.
VOLUME 12 NUMBER 1 SPRING 1999
103
estimation error. This latter component critically
depends on the relationship between interest rate
risk and market risk. If the uncertainty in equity
returns is driven by a simple factor process such as
t = Inflation
t
+ production
t
+ default risk
t
+ t (10)
6
where uncertainty in long bond returns (
t
) arising
from interest rate changes is a factor driving the
equity market as well, then the error term attached
to the equity risk premium in equation (9) will be
smaller than directly estimating the average equity
return. Anything that lowers the estimation risk is
beneficial, since with normal standard errors the
estimated average returns are subject to considerable
estimation error.
7
Third, the risk premium estimated from equa-
tion (9) will only be accurate if the average term
premium is equal to the current term premium,
otherwise there will be what I will call a term
premium bias. Equity market returns distill the effect
of all risks, so that it might be reasonable to assume
that this overall market risk is constant. However,
bond market returns are driven mainly by interest
rate changes, and it is questionable to assume that
this term premium has remained constant over the
full time period.
Finally, although equation (6) assumes that
equity returns are generated as a risk premium over
a risk-free rate, an alternative longstanding assump-
tion in finance is that nominal returns are generated
as a premium over the expected inflation rate. In
equation (6), this would mean that instead of the risk-
free rate bias, we would have an inflation rate bias.
That is, using the nominal average return implicitly
assumes that the average inflation rate over the
estimation period is equal to the current inflation
rate. This bias can be removed by calculating the
average real return by deflating the nominal return
by the change in the consumer price index. The
assumption would then be that the real equity return
follows equation (2).
The upshot of the above discussion is that it is
by no means certain that the equity return is better
estimated indirectly from a risk premium added to
a bond yield rather than directly from the proper-
ties of realized equity returns. All approaches in-
volve known biases and will be subject to estima-
tion error. It is a major theme of this paper that
which is the best approach can be determined only
after an analysis of the data and an understanding
of what economic events have occurred over the
estimation period. In contrast, the justification given
for the risk premium approach by Ibbotson and
Sinquefeld is based largely on assumption, not
analysis of the evidence.
WHAT THE DATA TELL US
Table 1 gives various estimates of the average
realized returns on different security classes for the
overall period 1926-1997.
8
Before discussing the
data it is useful to digress on what is meant by an
average rate of return. The arithmetic mean (AM)
is the simple average of the annual rates of return.
The geometric mean (GM) is the compound rate of
return earned between December 1925 and Decem-
ber 1997. The OLS is the ordinary least squares
estimate of the annual growth rate in wealth invested
in each asset class.
9
TABLE 1
ANNUAL RATE OF RETURN
ESTIMATES 1926-1997
S&P Long US 90 Day Real Excess
Equities Treasury Treasury Bills CPI Return Return
AM 12.95 5.59 3.80 3.20 9.75 7.36
Standard error 2.38 1.07 0.38 0.53 2.41 2.43
GM 10.99 5.22 3.75 3.10 7.89 5.77
OLS 10.91 4.17 3.75 3.79 7.12 6.74
standard error 0.20 0.19 0.18 0.12 N./A N./A
6. See for example, N. Chen, R. Roll and S. Ross, Economic Forces and the
Stock Market, Journal of Business, 59, 1986.
7. The standard error of the estimated mean is calculated in the normal way
as the standard deviation divided by the square root of the number of observations,
that is, the time period. With 72 years of data and an average equity volatility of
20%, the standard error of the estimate is over 2%, since the time period can not
usually be changed anything that lowers the standard errors makes for a more
accurate estimate of the unknown true expected equity return.
8. Data for 1926-1995 are the Ibbotson and Sinquefeld data on the CRSP data
files with 1996 & 1997 data updated manually. The estimates are obtained starting
from December 1925 from the monthly total return indexes.
9. The OLS estimate is obtained by a log-linear regression of the logarithm of
the cumulative wealth index against time, with the resulting continuous growth rate
converted to an effective annual rate by the anti-log function eX. Note the standard
error of this estimate reflects the lesser variability of total wealth as compared to
the annual return.
All of the approaches to calculating equity costs are subject to potential bias of one
kind or another, and there is thus no automatic right answer. Instead, capital
market evidence and knowledge of economic events should guide the users choice
among these different estimation techniques.
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JOURNAL OF APPLIED CORPORATE FINANCE
All three estimates of the average return are
valid and the choice between them depends on the
underlying reason for deriving the estimate. The GM
is the compound rate of return over the entire 72-year
period; essentially it is the single arithmetic return
that treats the whole period as a single period. In
contrast, the AM is the simple average of all the
annual rates of return. The AM always exceeds the
GM, and the difference increases by approximately
half the variance in the rate of return. As a result, the
difference between the AM and GM is greatest for the
common stock returns and smaller for the CPI and
90-day T-bill series. If the data is needed to assess
potential portfolio performance, and if the investors
holding period is between one and 72 years, then the
best estimator
10
is a weighted average of the AM
and GM with the weights depending on the particu-
lar holding period.
However, our concern is not with portfolio
performance, but with the estimation of the annual
rate of return required by an investor to discount
annual cash flows. For this purpose, the AM esti-
mated over annual holding periods is probably more
accurate, although the actual choice depends on the
unknown investment horizon.
The final estimate in Table 1 is the ordinary
least squares (OLS) estimate of the annual rate of
return, which (since it is assumed to be reinvested)
is also the growth rate in investors wealth. Unlike
the simple AM, which weights each annual return
equally, the OLS estimator minimizes the variance
in the forecast error. As a result, it should be a
statistically better estimator.
The message from the data in Table 1 seems to
be straightforward: common equities have earned
between 11-13% and long Treasuries 4-6%, on
average, depending on the estimation method. Thus,
the excess return of common stocks over long-term
government bonds has been in the range 6.7-7.4%
for annual holding periods, declining to 5.8% as the
holding period is lengthened. With long Treasury
yields at 6.0% in April 1998, adding the 6.7-7.4%
would yield a range of 12.7-13.4%. This estimate
would be at the top of the range derived from the
different estimates of the simple average nominal
equity return.
Over the same time period, the real equity
return has been between 7.1% and 9.8% for annual
holding periods with 7.9% for a longer horizon.
Note that the volatility of the inflation rate, particu-
larly in the 1930s, causes a significant difference
between the OLS and AM estimates of the average
real equity return. If a 2.5% inflation estimate is
added to the average real return estimates, the
nominal equity return would be in the 9.6%-12.2%
range, which is at the lower end of the range of
estimated simple nominal equity returns.
Clearly, the choice of estimation technique can
result in quite large differences in the estimate of
the expected equity return. This in turn would
mean large differences in estimates of the cost of
equity capital for different types of firms. Note also
that the standard error of the excess return esti-
mate is greater than the standard error of the
direct estimate, implying that the estimate of the
risk premium has not benefited from any interest
rate factor risk driving equity returns over the
whole period. The choice between the three
estimating techniques rests, therefore, on the
relative importance of the risk-free rate and
inflation rate biases of the direct estimates and
the term premium bias of the indirect risk
premium estimate.
One way of examining these potential biases is
to calculate annually updated averages from equa-
tions (6) and (9). Suppose, for example, that we
calculate the average from the first five observations
and then successively add additional observations.
If equation (6) holds for the equity return and the
risk-free and inflation rate biases are relatively
small, the estimated forward averagingprocess
will eventually zero in on the true mean.
Figure 1 illustrates this process, where the
rate of return is assumed to have a mean and
standard deviation of 12% and 20%, respectively.
For simplicity there are 72 observationsthe
same as for the time period in Table 1. Note that
while the average oscillates around 12%, the
fluctuation around the mean gets smaller and
smaller.
11
How much oscillation there is simply
depends on the initial random returns; large
outliers early on have a more dramatic effect
simply because they are averaged over fewer
observations. Surrounding the average are the
95% confidence bands for the estimate. Note that
the confidence bands get narrower, but since
10. See Marshall Blume, Unbiased Estimators of Long Run Expected Rates of
Return, Journal of the American Statistical Association, (September 1974).
11. Note that this was the result of one simulation, other simulations would
get different results.
VOLUME 12 NUMBER 1 SPRING 1999
105
they decline with the square root of the number
of observations (time), the effect of an increasing
time period decreases.
12
If the forward averaging exercise is repeated
with the actual data, we get the pattern shown in
Figure 2. There are three forward averaged series:
the nominal equity return, the real equity return,
and the excess return of equities over bonds.
Overall, all three series seem to exhibit a hump
in the middle years of 1950-1980, indicating in-
creasing returns and then decreasing equity re-
turns. This is particularly apparent with the real
equity and risk premium returns.
Although visual examination can be suspect,
since the variability in the equity return is so large,
there is little in the Figure 2 to suggest that one series
fits the random walk model better than another. If
anything, the simple average nominal equity return
seems to zero in on the average more quickly than
either the equity risk premium or the real equity
return average.
Another way to look at the data is to remember
that, from the random walk model of equation (6),
each years rate of return or risk premium is assumed
to be independent and drawn from the same distri-
bution. It follows that there is nothing special
about calculating an average starting out in 1926 and
then working forward to 1997. Instead, we can just
as well start from the average return for 1993-1997
and work backwards by adding historic data until
we again get the average for the full 72-year period.
(In fact, if the assumption that the return each year
is independent is not a valid one then, this process
may make more sense since it implicitly weights
current data more heavily.)
The pattern that results from this backwards
averaging process is shown in Figure 3. The last
observation at the right is for the period 1993-1997.
As one then moves towards the origin, progressively
older data is continuously added until the first
observation, marked 1926, adds the very first obser-
vation. This first (1926) observation thus represents
the overall average (and is the same as the last (1997)
observation in the forward average return graph
shown in Figure 2).
FIGURE 1
SIMULATED MEAN ESTIMATION: RANDOM WALK MODEL
FIGURE 2
FORWARD AVERAGING: 1926-1930 UNTIL 1926-1997
FIGURE 3
BACKWARDS AVERAGING: 1993-7 TO 1926-1997
12. With a 20% standard deviation of annual equity returns, the standard error
of the estimated average return is 6.3% with 10 observations, 2.0% with 100, and
1.4% with 200. We would have to wait 10,000 years to get an estimate accurate
within 20 basis points! Not many managers can wait this long.
The justification given for the risk premium approach by Ibbotson and Sinquefeld
is based largely on assumption, not analysis of the evidence.
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JOURNAL OF APPLIED CORPORATE FINANCE
A partial explanation for the results for the risk
premium average can be gained by looking at the
trend (shown in Figure 4) in fixed income yields over
time. Both the yield on long Treasuries and 90-day
T-bills are available back to 1934 and, when com-
bined, they certainly bracket the true risk-free rate
used in equity pricing. A simple visual examination
reveals that yields were quite constant until the early
1950s, when they began their long upward trend that
finished in the early 1980s; since then, they have
consistently trended downwards. Since it is the
change in yields that generates the uncertainty in the
holding period returns for long bonds, it is clear that
actual returns were lower than anticipated from the
1950s through 1980, and higher than anticipated in
the last 15 years or so. It is also clear that interest rate
risk and the term premium have not been constant
over the entire period.
Understanding the behavior of interest rates
over the last 72 years makes it clear that trends in
average equity returns and average equity risk
premiums have been affected by the significant
changes that have occurred in the bond market. It is
a reflection on the volatility in equity returns that the
clear trend in bond market yields and returns does
not generate a clearer pattern in the average equity
risk premiumone that would allow us to conclu-
sively state that whether or not the equity risk
premium series has followed a random walk with a
constant mean. However, although the saucer
shape of the average equity risk premium in Figure
3 could have resulted randomly, knowledge of the
trend in monetary policy that caused the temporal
change in market interest rates provides a clear
indication that the equity risk premium series has a
significant term bias.
WHAT HAS HAPPENED TO BOND MARKET
RETURNS?
The previous averaging data indicated that
neither the averages nor their volatility have been
constant over time, and that changes in the bond
market were a likely source of some of the prob-
lems. One way of looking at this is to examine
rolling instead of updated averages to see whether
either the average return or the volatility has changed
over time.
FIGURE 4
FIXED INCOME YIELDS
13. Variance ratio tests and Q autocorrelation tests indicate the absence of
significant autocorrelation in annual returns over the whole time period.
The interesting point about the backwards av-
eraging graph in Figure 3 is that, for all three series,
the average decreases as you add older data until
about 1966 (or 1980, in the case of the risk premium
average). At this point, they all begin to increase
before zeroing in on the long run average. Contrast-
ing the forward and backward averages, it is difficult
not to conclude that the latest period has witnessed
higher equity returns than the earlier period. This
conclusion comes from the slow oscillation in the
backwards averaging graphparticularly for the risk
premium average, which shows a definite saucer
shape. For the earliest period, there is initially more
volatility (but, as will be discussed later, it was a delib-
erate decision to create the Ibbotson and Sinquefeld
data starting five years prior to the most extreme value
of allthe 1929 stock market crash). As a result, the
1925 start date was not chosen randomly and the for-
ward averaging from 1925 is inherently biased.
The conclusion drawn from the forward and
backward averaging graphs in Figures 2 and 3 is that
there is so much volatility in the equity return series
that it is difficult to state conclusively whether any of
the series fits the random walk model with a constant
mean and variability. In fact, none of the series seem
to be free of bias, with the risk premium series having
the more obvious problems.
13
This in turn implies
that none of the simple averages can be used as a
naive forward-looking estimate for calculating dis-
count rates. This conclusion is particularly apt for the
risk premium series.
VOLUME 12 NUMBER 1 SPRING 1999
107
Figure 5 shows the standard deviation (volatil-
ity) of actual equity and bond returns over a rolling
ten-year period starting in 1926-1935 and ending
with the period 1988-1997. The choice of a ten-year
window is arbitrary, but it should capture a long
enough period to include a full business cycle and
yet be short enough to capture changes over time.
Some immediate implications are apparent.
First, note that equity market risk peaked during the
1930s, when as we saw earlier the forward average
return suffered the most oscillation, and then seems
to have declined ever since, punctuated by in-
creases caused by periodic major market move-
ments. Although this is probably the result of choos-
ing the 1925 start date, there is little in the data to
indicate that equity market risk has increased. In
fact, the data suggest the oppositenamely, that
equity market risk has been on a long-run secular
decline since the 1930s.
Also note that, in contrast to the equity market,
bond market risk has undoubtedly increased. Bond
market risk seemed to have been moderate in the
1930s, before declining into the 1940s and 1950s, a
period during which interest rates were tightly
controlled. As a result, there was relatively little bond
market uncertainty until 1982, when interest rates
plummeted.
14
From 1982 to 1997, the ten-year stan-
dard deviation of bond market returns was essen-
tially the same as the declining risk in the equity
market (even after the huge gains of 1982 rolled out
of the ten-year estimation window).
This change in bond market relative to equity
market risk raises questions about the assumption
(in equations (6) and (7)) that the error terms
generating equity and bond market uncertainty are
constant. In practice, it seems highly unlikely that
returns have been generated by processes with
constant error terms. A better working assumption
would be that the error term in equation (7) has
increased for bond market returns, while possibly
decreasing for the equity market. Moreover, if the
relative uncertainty has changed, it also seems likely
that investors have reacted by changing their ex-
pected return requirements. Why, for example,
would investors expect the same return from equi-
ties in the 1990s as in the 1930s, when equities have
been half as volatile? Moreover, why would investors
in the 1990s expect the same risk premium of equities
over long bonds as in the 1930s when stocks and
bonds had roughly the same level of riskas
compared to the 1930s when equities were six times
as volatile?
I will return to the equity market later, but there
are also more direct implications for the bond
market. If investors hold diversified portfolios, what
does the increased bond market risk mean for their
overall portfolio? That is, how much of the increased
interest rate risk is diversifiable?
Figure 6 shows the rolling bond market beta.
It is estimated from ten years of annual data (rather
than the normal five years of monthly data) to cap-
ture the effects of the assumed annual holding pe-
riod. What is immediately apparent is that the in-
crease in bond market volatility has been closely
associated with the levels of bond market betas. In
the 1930s, bond betas were of the order of 0.10, and
then they declined when interest rate controls were
imposed. They did not become significant again until
the 1980s. But, by 1990 (covering the period 1981-
1990), bond market betas had climbed to about 0.80!
Clearly, bond market uncertainty has had a system-
atic as well as an unsystematic component.
Figure 7 shows rolling bond market betas
estimated using a five-year window and monthly
rates of return. There is no reason risk should be the
same for a monthly as an annual investment hori-
FIGURE 5
UNCERTAINTY IN FINANCIAL MARKETS:
STANDARD DEVIATION OF RETURNS OVER ROLLING
TEN YEAR YEAR PERIODS
14. Note that higher interest income was offsetting capital losses on bonds as
interest rates increased. As a result, returns were less than anticipated, but bond
market volatility did not increase with the general level of interest rates. For
example, in 1979, 1980 and 1981 bond market returns were 1.2%, -3.9% and 1.9%,
in 1982 the return was 40.4% as higher interest income was combined with large
capital gains.
The choice of estimation technique can result in quite large differences in the
estimate of the expected equity return. Moreover, the standard error of the excess
return estimate is greater than the standard error of the direct estimate, implying
that the estimate of the risk premium has not benefited from any interest rate
factor risk driving equity returns over the whole period.
108
JOURNAL OF APPLIED CORPORATE FINANCE
zon, and a comparison of Figures 6 and 7 clearly
shows this. For example, although the beta esti-
mates show the same general patternlow esti-
mates initially, followed by a decline and then an
increase, as interest rates became increasingly more
volatilethere are differences. As the investment
horizon shortens, price volatility dominates income
volatility. Moreover, with a shorter window, ex-
treme unusual events pass out of the estimation
window more quickly. For example, the five-year
betas drop precipitously starting in October 1987.
The reason for this is the stock market crashed by
21.5%, and to prevent panic the Federal Reserve
lowered interest rates, causing a 6.2% bond market
return. This one negative correlation is so large that
all monthly estimates that include October 1987
show a break. As October 1987 passed out of the
five-year window in October 1992, beta estimates
started to increase again.
15
The above discussion of five-year versus ten-
year bond betas is important for two reasons. First,
it emphasizes the earlier conceptual problem with
investment horizons. Overall, 1987 was a good year
for the stock market, it actually went up by 5.2%,
while the bond market went down by 2.7%. As a
result, an investor with a one-year horizon would
look at 1987 differently from one with a one-month
horizon. Second, and more fundamental, risk doesnt
disappear just because an event has not happened
during a particular estimation period. Bond market
risk didnt increase in October 1992 simply because
there was no crash in the previous five-year period
and, as a result, no opportunity for bonds to demon-
strate their attributes as a safe harbor.
Even accounting for the subtleties of estimat-
ing bond market risk, it is clear from both the five-
and ten-year bond market betas, as well as the
volatility estimates, that bond market risk has sub-
stantially increased in the last third of the period
1926-1997. It is highly unlikely, as a result, that the
term premium demanded by long-term bond inves-
tors was the same in this latter period as in the
earlier period. As a result, the term premium bias
in using the equity risk premium over bond yield
method is likely to be substantial. For example, in
equation (8) the implicit term premium subtracted
from the estimated average risk premium will be
weighted 2/3rds for the period when the term
premium was very low and only 1/3rd for the latter
period, when it was high. This risk premium will
then be added to a current long-term bond yield
that fully reflects the current term premium. As a
result, the bond yield plus method will unambigu-
ously overestimate equity discount rates.
To put the same thing a little differently, if
interest rate risk is a factor in market risk (as the large
and significant bond market betas indicate), then
bonds should be priced according to the CAPM as
well as equities. In this case, the equity risk premium
over long term bonds is as follows:
ERP = (E(R
M
) R
F
) * (
e

l
) (11)
FIGURE 6
US TREASURY BETAS
FIGURE 7
BOND MARKET BETAS
15. In daily data, as an extreme, almost all the volatility is from price changes.
VOLUME 12 NUMBER 1 SPRING 1999
109
In the earlier period, where the bond market
risk was low (with bond betas of 0.1), the estimated
excess return of equities over long term bonds was
estimating almost the full equity risk premium. But,
in the later period when bond market risk was high
(with bond betas of 0.8) it is only estimating part of
the full risk premium. Adding an average of these
excess returns to the current risky long term bond
yield will produce an upward-biased equity cost. In
fact, if current bond beta estimates of 0.5-0.6 are
valid, the risk premium of low risk equities over long
term bonds should be close to zero. This has major
implications for low-risk stocks, like regulated utili-
ties, that have betas in the 0.5-0.6 range, and yet
estimate equity costs by the bond yield plus method.
WHAT HAS HAPPENED TO EQUITY MARKET
RETURNS
If the evidence from the bond market is that the
term premium bias in the average equity risk pre-
mium estimate is significant, what about the equity
market and the risk-free and inflation rate biases
discussed earlier? Here what is important is that, once
we recognize that the term premium bias invalidates
the average excess return over bonds (and that the
excess return over T-bills is not a meaningful num-
ber), we should then look objectively at the data on
equity market returns in isolation from the bond and
bill markets.
Data on the equity market has been pushed
back to 1802 by Schwert.
16
However, the earlier
period only includes railroads and financial firms.
In an article published in 1987, Wilson and Jones
17
cleaned up the original Cowles data set that
extends back to 1871. As Wilson and Jones explain,
this is data of comparable quality to the Ibbotson
and Sinquefeld data that starts in December 1925.
The only reason for starting in December 1925 was
Fisher and Lories
18
desire to capture at least a full
business cycle before the 1929 stock-market crash,
a practice followed by Ibbotson and Sinquefeld.
This in turn explains why the equity return series
does not start at a random point in time, instead it
deliberately starts five years prior to the great crash,
which biases both the volatility and average return
estimates. The Cowles data starts in 1871, when it
consisted of 31 railroads, 4 utilities, and 13 industri-
als; by 1925 it consisted of 29 railroads, 22 utilities,
and 207 industrials. The 1871 start date is random in
turns of subsequent return estimates, since it was
chosen for other reasons.
19
The forward averaging of the returns is re-
peated for the overall period in Figure 8. Note that
the nominal return does not seem to have a con-
stant mean. The series oscillates for the first 20 years
or so, but then increases almost continuously from
the low around 1890. In contrast, the forward
average of the real equity returns starts out higher
(since there was deflation almost throughout the
latter part of the 19th century), and finishes lower
(because of the more recent inflationary period).
The average of the real equity return looks more
like a random walk with a constant mean, since it
does not show a drift over time.
The backwards averaging is shown in Figure 9.
Again the last observation on the right is for the
period 1993-1997 and, as the data moves closer to the
origin, older data is added until the first observation
for 1871, which is the average for the whole period
1871-1997. Note that the averages again fall, reflect-
FIGURE 8
FORWARD AVERAGING: FROM 1871-1875 TO 1871-1997
16. G. William Schwert, Indexes of Common Stock Returns from 1802 to
1987, Journal of Business 63-3, 1990.
17. J. W. Wilson and C. P. Jones, A Comparison of Annual Common Stock
returns: 1871-1925 with 1926-1985, Journal of Business 60-2, 1987. This is also the
source of the early inflation data.
18. L. Fisher and J. Lorie, Rates of Return on Investments in Common Stocks,
Journal of Business 37-1, 1964.
19. The original Cowles data apparently started in 1871 for two main reasons:
first, prior to that date the market was basically railroad stocks; second there were
a large number of changes in both securities regulation and trading rules on the
NYSE introduced in the 1860s. Neither reason is cause for concern that the start
date was chosen specifically to include particular return observations.
If current bond beta estimates of 0.5-0.6 are valid, the risk premium of low risk
equities over long term bonds should be close to zero. This has major implications
for low-risk stocks, like regulated utilities, that have betas in the 0.5-0.6 range.
110
JOURNAL OF APPLIED CORPORATE FINANCE
ing the recent equity bull market, but that the
nominal average continues to fall almost continu-
ously through to 1871. In contrast, the average of the
real returns falls through to 1971, increases back to
1951, and then zeros in on the long-run average.
Again, of the two series, only the average of the real
equity return seems to be consistent with a random
walk model with a constant expected (real) return.
If the average real equity return seems to be the
only candidate for a simple estimate of the long-run
equity market return, we need to determine if the
long-run average hides obvious periods of vary-
ing returns. To see this, Figure 10 gives the rolling
ten-year average of the real equity return. Over the
whole time period, the average real equity return
was 9.02%, and the standard error of the estimate is
1.71%.
20
However, for an estimate from ten years of
data the standard error is 6.1%, so that we can
expect, with a 95% confidence interval, the ten-year
average real return estimate to be between about
13% and 21%! The actual mean estimates are just
within this range, but the significant point is that
there does not seem to be any trend across time.
Current average real equity returns are close to the
high teens that were experienced prior to the 1929
stock market crash and the high inflation period of
the 1970s, both of which subsequently saw much
lower real equity returns.
In Figure 11, the volatility of real equity market
returns is measured in the same way as a rolling ten-
year standard deviation of real returns. Similar to the
average equity return, the volatility is subject to
estimation error and fluctuates quite widely depend-
ing on whether or not an extreme value occurs
during the rolling ten-year period. For example the
standard deviation of real equity returns was about
19% until 1889, when the 57% gain of 1879 dropped
out of the estimation window. The volatility then
stayed around 12-13% until 1907 when the real
equity return was 30.8% followed by +47% in 1908.
Overall, between 1871 and 1997, the standard devia-
tion of real equity returns was 19.24%.
A final way of looking at the volatility of real
equity returns is to graph the absolute value of their
annual returns (see Figure 12). The reason for
FIGURE 9
BACKWARDS AVERAGING: FROM 1993-1997 TO 1871-1997
FIGURE 10
AVERAGE REAL EQUITY RETURNS: ROLLING 10 YEAR
AVERAGE
FIGURE 11
VOLATILITY IN REAL EQUITY: ROLLING 10 YEAR
ESTIMATE
20. The average nominal return was 11.04% with a standard error of 1.67%
VOLUME 12 NUMBER 1 SPRING 1999
111
looking at absolute values is that it is the magnitude
of the extreme returns that causes the fluctuation in
the volatility estimate and not their sign. Drawing
inferences as to whether the equity market has
become more volatile over the last 129 years from
Figure 12 is extremely difficult. Major market move-
ments seem to occur every 20 to 30 years and have
done so for the last 129 years. Also the Great Crash
of 1929 is an outlier, primarily because it was a
downwards correction, though annual returns of a
similar magnitude have occurred at other times in
the past.
21
In sum, the volatility figures shown above
suggest that Ibbotson and Sinquefelds choice of
1925-1997 data (with its start date so close to the
Great Crash) is largely responsible for the conclu-
sion that risk has decreased in the equity market. If
we instead use data going back to 1871, it becomes
much more difficult to justify a decreasing risk
conclusion. Instead, it is hard not to conclude that
the equity return is approximately driven by a real
return process with a mean of about 9.0% and a
constant error term.
CONCLUSION
Estimating discount rates is a critical part of
finance. The standard approach based on risk-based
pricing models, such as the CAPM, is to estimate
equity returns based on a risk-free rate plus a risk
premium. For conventional valuation and capital
budgeting purposes it is well accepted that the risk-
free rate should be a long Treasury yield. In contrast,
Ibbotson and Sinquefeld suggest that the equity risk
premium be estimated over Treasury bills, based on
the assumption that the equity risk premium, and not
the full equity return, follows a random walk with a
constant mean. This idea has also been adopted for
estimating equity returns as a premium over long
bond yields, with the implicit assumption that the
excess return of equities over long bond returns also
follows a random walk.
In this paper, the assumptions underlying these
estimation techniques have been investigated. Three
specific models have been examinednamely, that
(1) the nominal equity return, (2) the real equity
return and (3) the equity risk premium over long
bonds each follows a random walk with a constant
mean. All of these models cannot be true simulta-
neously, and a priori none of them is expected to be
true. If nominal returns are determined as a true risk-
free rate plus a constant equity risk premium, there
will be a risk-free rate bias to using the nominal
equity return as an estimate of future equity returns.
Similarly, if the nominal return is determined as a
constant real rate over the expected inflation rate,
then there will be an inflation rate bias to the average
nominal return. In this case, the bias can be removed
by looking at realized real equity returns. Finally, if
the riskiness of equity or bonds has changed over
time, the equity risk premium will be distorted by a
term premium bias.
The main conclusions of this paper are as
follows:
(1) Examination of bond market performance
and market interest rates experienced since 1925
make it abundantly clear that the term premium
bias is significant. As a result, the long- run realized
excess equity return over long-term bonds cannot
be used as a risk premium to add to current long-
term bond yields.
(2) Total bond market risk (as measured by
standard deviation of returns) has significantly in-
creased over the last 20 years, and at times has been
almost equal to that of the equity market. This
indicates that the equity risk premium over long term
bonds is unlikely to have been constant.
FIGURE 12
ABSOLUTE ANNUAL RETURNS
21. Note all the return estimates are simple annual rates of return, they are not
the log relative, which would follow from a continuous time lognormal model of
stock prices.
Ibbotson and Sinquefelds choice of 1925-1997 data (with its start date
so close to the Great Crash) is largely responsible for the conclusion that
risk has decreased in the equity market. If we instead use data going back to 1871,
the equity return appears to be driven by a real return process with a mean of
about 9.0% and a constant error term.
112
JOURNAL OF APPLIED CORPORATE FINANCE
(3) Bond market betas, whether measured based
on ten-year annual returns or five-year monthly
returns, have increased from the negligible level
prior to the 1970s to the 0.40-0.80 range by 1990s.
As a result, conventional risk premiums over long-
term bond yields that may have been valid in
earlier periods are excessive in the current interest
rate environment.
(4) With bond market betas of 0.40-0.80, risk
premiums for lower risk equity securities, such as
utilities, should be close to zero.
(5) When equity market data back to 1871 is
examined, the nominal equity return has clearly not
followed a random walk with a constant mean. As a
result, it is not reasonable to take an average nominal
equity return over even a very long period as a proxy
for expected nominal equity returns. The inflation
rate bias indicates that this average nominal return
will only by coincidence be an accurate estimate of
future nominal equity returns.
(6) The real equity return, in contrast to the nominal
equity return, seems to show no major drift over time,
whether it is averaged forwards or backwards.
(7) The standard error of the real return estimate
of 1.71% means that estimating the average return
over short time periods (say ten years) is subject to
considerable estimation risk. Indeed, estimating the
average equity return to within 1.0% of the true mean,
if it is in fact constant, will take about 400 years.
(8) The standard deviation of real equity returns
has averaged about 19%, and fluctuated between
12% and 30%, based on ten-year estimates. The
estimates are critically dependent on the timing of
periodic major market movements and whether or
not they happen to fall within the estimation win-
dow. Overall, there is little to suggest that over the
whole period 1871-1997 stock market risk has changed
significantly . There is evidencefocusing only on
the Ibbotson and Sinquefeld period that starts in
1925that equity risk has declined. However, this
conclusion is due to the extreme stock market
volatility at the time of the Great Crash of 1929, which
determined the start point of their time period in the
first place!
The above conclusions are broad and impor-
tant, but the central message is simple: The familiar
approach of adding a constant equity risk premium
to the long-term bond yield is suspect, as long as the
equity risk premium is mechanically estimated as a
simple average of past excess returns. Instead,
examining the broad scope of stock market history
would suggest that a better forecasting method is to
add a current inflation expectation to the average
real equity return of about 9.00%. At the current point
in time, this would probably indicate an equity return
of just over 11.0%, rather than the 13% plus obtained
from adding an historic equity risk premium to a
current long Treasury yield.
LAURENCE BOOTH
holds the Newcourt Chair in Structured Finance at the University
of Torontos Rotman School of Management.
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