The equity premium is the return earned by a risky security, such as a stock, in excess of that earned by a risk free security, such as a Treasury Bill. It is a crucial input into financial decisions as diverse as asset allocation, capital budgeting and planning for retirement. Historical data provide a wealth of evidence documenting that over long periods of time, stock returns have been considerably higher than the returns for T-bills. The average annual real return (that is, the inflation-adjusted return) on the U.S. stock market for the past 115 years has been about 7.5 percent. In the same period, the real return on a relatively riskless security was a paltry 1.0 percent. The difference between these two returns, 6.5 percentage points, is the equity premium. The dramatic investment implications of these differential rates of return is illustrated below.
Investment Period | Stocks | T-Bills | Ratio |
---|---|---|---|
1889-2004 | $4092.36 | $3.14 | 1,303.30 |
1926-2004 | $407.56 | $1.67 | 244.05 |
1947-2004 | $61.70 | $1.33 | 46.39 |
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