• Selected
• Entire List

Abstract:
We use a new database of long-run stock, bond, bill, inflation, and currency returns to estimate the equity risk premium for 17 countries and a world index over a 106-year interval. Taking U.S. Treasury bills (government bonds) as the risk-free asset, the annualised equity premium for the world index was 4.7% (4.0%). We report the historical equity premium for each market in local currency and US dollars, and decompose the premium into dividend growth, multiple expansion, the dividend yield, and changes in the real exchange rate. We infer that investors expect a premium on the world index of around 3-3 1/2% on a geometric mean basis, or approximately 4 1/2-5% on an arithmetic basis.

Equity risk premium, long run returns, survivor bias, financial history, stocks bonds bills inflation

Abstract:
Theory on the pricing of financial assets can be traced back to Bernoulli's famous St. Petersburg paper of 1738. Since then, research into asset pricing and derivative valuation has been influenced by a couple of dozen major contributions published during the twentieth century. These seminal works have underpinned the key ideas of mean-variance optimisation, equilibrium analysis and no-arbitrage arguments. This paper presents a historical review of these important contributions to finance.

Abstract:
Theory on the pricing of financial assets can be traced back to Bernoulli's famous St. Petersburg paper of 1738. Since then, research into asset pricing and derivative valuation has been influenced by a couple of dozen major contributions published during the twentieth century. These seminal works have underpinned the key ideas of mean-variance optimisation, equilibrium analysis and no-arbitrage arguments. This paper presents a historical review of these important contributions to finance.

Abstract:
We address the tendency of many investors to overestimate the rewards and underestimate the risks of investing in stocks over the long term - that is, investors' irrational optimism. In particular, we examine the widely held belief that stocks are a "safe" investment for the long run. The probability of experiencing a real loss on equities depends on the expected real return and standard deviation of stocks. Judgments about the future magnitude of these two parameters typically involve extrapolating from history. We use a global database of real equity returns from 16 countries during the 103-year period from 1900 through 2002 to confront the optimism of investors with the reality of history.

Since 1900, the worldwide real return on equities averaged close to 5 percent a year (before costs, fees, and taxes). This is appreciably lower than is frequently quoted from historical averages, a difference that arises because we use a longer time frame than other studies and adopt a global focus. Prior views on the long-run safety of equities have been overly influenced by the experience of the United States. Furthermore, the US evidence that, over the long haul, stocks have beaten inflation over all 20-year periods is based on relatively few nonoverlapping observations and is hence subject to large sampling error.

To counteract this dependency on projections of the US experience, we examine the histories of other countries. We find only three non-US equity markets (with a fourth on the borderline) that never experienced a shortfall in real returns over a 20-year period. The worst 20-year real returns of 11 countries were negative. Historically, in 6 of the 16 countries, investors would need to have waited more than 50 years to be assured of a positive return.

We also analyze the future shortfall risk of an equity portfolio. The base case for the projections is a worldwide historical volatility level of 20 percent and mean real return of 5 percent, and we also examine a lower return of 4 percent. The projected shortfall risk exceeds the historical risk of shortfall - partly because of the lower assumed real returns, and partly because, even though volatility was projected to be the same as in the past, the shortfall analysis focuses on the full range of possible future returns rather than a single historical outcome. By construction, historical returns converged on long-term realized performance, but the forward-looking analysis shows that there is always risk from investing in volatile securities.

Although the probable rewards from equity investment are attractive, stocks did not and cannot offer a guaranteed superior performance over the investment horizon of most investors. Furthermore, their prospective returns are lower than many investors project, whereas their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational.

Portfolio management: asset allocation; equity investments: fundamental analysis and valuation models

Abstract:
We address the tendency of many investors to overestimate the rewards and underestimate the risks of investing in stocks over the long term - that is, investors' irrational optimism. In particular, we examine the widely held belief that stocks are a "safe" investment for the long run. The probability of experiencing a real loss on equities depends on the expected real return and standard deviation of stocks. Judgments about the future magnitude of these two parameters typically involve extrapolating from history. We use a global database of real equity returns from 16 countries during the 103-year period from 1900 through 2002 to confront the optimism of investors with the reality of history.

Since 1900, the worldwide real return on equities averaged close to 5 percent a year (before costs, fees, and taxes). This is appreciably lower than is frequently quoted from historical averages, a difference that arises because we use a longer time frame than other studies and adopt a global focus. Prior views on the long-run safety of equities have been overly influenced by the experience of the United States. Furthermore, the US evidence that, over the long haul, stocks have beaten inflation over all 20-year periods is based on relatively few nonoverlapping observations and is hence subject to large sampling error.

To counteract this dependency on projections of the US experience, we examine the histories of other countries. We find only three non-US equity markets (with a fourth on the borderline) that never experienced a shortfall in real returns over a 20-year period. The worst 20-year real returns of 11 countries were negative. Historically, in 6 of the 16 countries, investors would need to have waited more than 50 years to be assured of a positive return.

We also analyze the future shortfall risk of an equity portfolio. The base case for the projections is a worldwide historical volatility level of 20 percent and mean real return of 5 percent, and we also examine a lower return of 4 percent. The projected shortfall risk exceeds the historical risk of shortfall - partly because of the lower assumed real returns, and partly because, even though volatility was projected to be the same as in the past, the shortfall analysis focuses on the full range of possible future returns rather than a single historical outcome. By construction, historical returns converged on long-term realized performance, but the forward-looking analysis shows that there is always risk from investing in volatile securities.

Although the probable rewards from equity investment are attractive, stocks did not and cannot offer a guaranteed superior performance over the investment horizon of most investors. Furthermore, their prospective returns are lower than many investors project, whereas their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational.

Portfolio management, asset allocation, long-run returns, shortfall analysis

Abstract:
Many researchers have uncovered empirical regularities in stock market returns. If these regularities persist, investors can expect to achieve superior performance. Unfortunately, nature can be perverse. Once an apparent anomaly is publicised, only too often it disappears or goes into reverse. The latter seems to have happened to the small firm premium. After the UK size premium was documented and disseminated, a historical small-cap premium of six percent was followed by a small-cap discount of around six percent. This study presents evidence of and some explanations for the disappearance of the small firm premium.

Abstract:
Many researchers have uncovered empirical regularities in stock market returns. If these regularities persist, investors can expect to achieve superior performance. Unfortunately, nature can be perverse. Once an apparent anomaly is publicised, only too often it disappears or goes into reverse. The latter seems to have happened to the small firm premium. After the UK size premium was documented and disseminated, a historical small-cap premium of six percent was followed by a small-cap discount of around six percent. This study presents evidence of and some explanations for the disappearance of the small firm premium.

Abstract:
Investors have too often extrapolated from the American experience and from relatively recent evidence. In the 1950s, who but the most rampant optimist would have dreamed that, over the next fifty years, the real return on equities would be 9 percent per year? Yet this is exactly what happened in the US stock market.

In this study we extend our knowledge of financial market performance across regions and across time. We present a comprehensive and consistent analysis of investment returns for equities, bonds, bills, currencies, and inflation, spanning sixteen countries from the end of the nineteenth century to the beginning of the twenty-first. Our indexes are chosen to avoid survivorship bias, and all returns include reinvested income. This enables us to study topics such as the size effect, the value premium, interest rates and inflation, dividend growth, and the equity risk premium over more than a century.

The markets we cover comprise two in North America, seven in the Euro area, four others in Europe, two in the Asia-Pacific region, and one in Africa. We present in this extract from our work a summary of capital market history in all sixteen countries. We find that over the long haul stocks beat bonds in every market, and bonds beat bills almost everywhere.

The full study is forthcoming as a book, 'Triumph of the Optimists: 101 Years of Global Investment Returns', to be published by Princeton University Press in February/March 2002

Long-term returns, equity risk premium, financial market history, survivor bias

Abstract:
Most long-run empirical research on the historical risk premium has focused on the experience of the United States. However, the United States has been a remarkably successful economy, making it unlikely that the US risk premium is representative. Until recently, evidence on the risk premium in most other countries has typically been measured over only relatively brief intervals during the latter part of the twentieth century. We extend the evidence by examining equity, bond, and bill returns in 16 different countries over the 103-year period from 1900 to 2002. We show that the equity risk premium has typically been lower than most previous research has indicated. Finally, we argue that even this lower figure for the historical risk premium is still an overestimate of the likely future risk premium.

Equity risk premium, Long-term returns, Financial history, Survivorship, Required rate of return

Abstract:
Most long-run empirical research on the historical risk premium has focused on the experience of the United States. However, the United States has been a remarkably successful economy, making it unlikely that the US risk premium is representative. Until recently, evidence on the risk premium in most other countries has typically been over only relatively brief intervals during the latter part of the twentieth century. We extend the evidence by examining equity, bond, and bill returns in 16 different countries over the 103-year period from 1900 to 2002. We show that the equity risk premium has typically been lower than most previous research has indicated. Finally, we argue that even this lower figure for the historical risk premium is still an overestimate of the likely future risk premium.

Equity risk premium, Long-term returns, Financial history, Survivorship, Required rate of return

Abstract:
This survey reviews the evolving literature on closed-end fund discounts. Many studies have attempted to explain the existence and the behavior of the discount to net asset value, emphasizing biases in the calculation of NAV, agency costs, tax-timing options and market segmentation. None has been able to provide a full explanation. As a result, some researchers have found it necessary to resort to models of limited rationality. This gives rise to potential opportuniteis for exploiting the discount. We summarize the findings from some 70 studies of closed-end funds, and present directions for future research.

Abstract:
We examine a set of equity index-linked bonds that provide the same payout as an investment in an equity index, but are relatively illiquid. We demonstrate that these securities sell at a discount relative to their underlying value and hence have higher expected returns. We show that this apparent mispricing can be attributed to the illiquidity of the bonds. Trading costs for equity-linked bonds, as measured by bid-ask spreads, are free of any asymmetric information or inventory holding cost component; hence the only illiquidity component left is clearing costs. This study shows that, even in the absence of asymmetric information and inventory holding costs, illiquidity depresses asset prices and therefore increases expected security returns. Using an ex ante measure of the expected return premium due to illiquidity, we link the time-series variation in the lliquidity premium to security-specific attributes related to their marketability. We show that liquidity risk has a systematic component, and relate this market-wide factor to a number of macroeconomic variables that have previously been shown to be related to illiquidity.

Liquidity, Asset Pricing

Abstract:
We examine a set of equity index-linked bonds that provide the same payoff as an investment in an equity index but are relatively illiquid. We demonstrate that these securities sell at a discount relative to their underlying value and hence have higher expected returns. We show that this apparent mispricing can be attributed to the illiquidity of the bonds. Trading costs for equity-linked bonds, as measured by bid-ask spreads, are free of any asymmetric information or inventory holding cost component; hence the only illiquidity component left is clearing costs. This study shows that even in the absence of asymmetric information and inventory holding costs, illiquidity depresses asset prices and therefore increases expected security returns. We have time series for more than a decade of a clean measure of the expected return premium due to illiquidity. This enables us to link time variation in the illiquidity premium to security-specific attributes related to their marketability. We show that liquidity risk has a systematic component, and relate this market-wide factor to a number of macroeconomic variables that have previously been shown to be related to illiquidity.

Illiquidity, equity returns

Abstract:
This paper examines the performance of the leading methods for setting capital requirements for securities firms' trading books. Tests are conducted on a large sample of UK equity market makers' books over a substantial number of periods of equity market stress from 1985 to 1995. The comprehensive and building-block approaches, favored by US and European regulators, fail to provide effective cover. Only portfolio-based, value-at-risk type models are efficient in providing appropriate levels of capital to cover the position risk of equity trading books.

Abstract:
Using a new dataset of accounting information merged with share price data we find a strong value premium in the U.K. for the period 1955-2001. It exists among small-caps as well as among large-caps. However, there are challenges for small-cap managers wishing to capture these higher expected returns. We show that rebalancing-induced portfolio turnover for indexed small-value strategies can be substantial. Coupled with the relative illiquidity of the U.K. market for small-value stocks, this calls for strategies that sacrifice tracking accuracy in favor of reduced trading needs and lower trading costs.

Value Premium, Book-to-Market, Trading Cost

Abstract:
Improvements in technology and increasing emphasis on performance have led many investors to monitor the performance of fund managers on a high frequency basis: quarterly, monthly, or more often. We examine the impact that frequency of performance measurement has on the probability distribution of observed outcomes. With more frequent monitoring of rolling returns, there is a greatly increased probability of observing seemingly extreme results. We show that if performance is appraised by focusing on returns to date, then it is important to adjust the definition of extreme performance for the frequency with which returns are monitored. Failure to do so may lead to costly actions such as strategy revisions or manager terminations, which increase transaction costs and have detrimental effects on manager incentives.

Performance measurement, Investment management, High frequency monitoring

Abstract:
Improvements in technology and increasing emphasis on performance have led many investors to monitor the performance of fund managers on a high frequency basis: quarterly, monthly, or more often. We examine the impact that frequency of performance measurement has on the probability distribution of observed outcomes. With more frequent monitoring of rolling returns, there is a greatly increased probability of observing seemingly extreme results. We show that if performance is appraised by focussing on returns to date, then it is important to adjust the definition of extreme performance for the frequency with which returns are monitored. Failure to do so may lead to costly actions such as strategy revisions or manager terminations, which increase transaction costs and have detrimental effects on manager incentives.

Performance measurement; Investment management; High frequency monitoring

Abstract:
A central measure of the efficiency of the Initial Public Offering (IPO) market is the extent to which issues are underpriced. Legal, regulatory, disclosure and underwriting pressures have moulded the IPO market since World War II. This paper presents new and comprehensive evidence covering British IPOs since World War I. We find that during the period from 1917 to 1945, public offers were underpriced by an average of only 3.80%, as compared to 9.15% in the period from 1946 to 1986, and even more after the UK stock market was deregulated in 1986. The post-WWII rise in underpricing cannot be attributed to changes in firm composition, and occurred in spite of improvements in regulation, disclosure, and the prestige of IPO underwriters.

Initial public offering, underpricing, regulation, investor protection, financial history

Abstract:
This paper uses stamp catalogue prices to investigate the returns on British collectible postage stamps over the period 1900–2008. We find an annualized return on stamps of 6.7% in nominal terms, which is equivalent to 2.7% in real terms. These returns are higher than those on bonds but below those on equities. The volatility of stamp prices approaches that of equities. Stamp returns are impacted by movements in the equity market, but the systematic risk of stamps remains low. Estimates of average after-cost returns for individual investors show that stamps may rival equities in terms of realized performance.

Alternative investments, Indexes, Long-term returns, Philately, Stamps

Abstract:
Using a new data set of accounting information merged with share price data, we found a strong value premiumin in the United Kingdom for the period 1955-2001. It existed among small-capitalization and large-capitalization stocks. But small-cap stock managers who wish to capture the higher expected returns face some challenges. We show that rebalancing-induced portfolio turnover for indexed small-cap value strategies can be substantial. Coupled with the relative illiquidity of the U.K. market for small-cap value stocks, such high turnover calls for strategies that sacrifice tracking accuracy in favor of reducing trading needs and lowering trading costs.

Portfolio Management, equity strategies

Abstract:
The single most important contemporary issue in finance is the equity risk premium. This drives future equity returns, and is the key determinant of the cost of capital. The risk premium, the expected reward for bearing the risk of investing in equities, rather than in low-risk investments such as bills or bonds, is usually estimated from historical data. This article starts by summarising new evidence on historical returns in twelve major world markets from the authors' recent book, 'The Millennium Book: A Century of Investment Returns'. The authors show that the historical equity risk premium has been lower than previously believed, and argue that the future risk premium is likely to be lower still. They discuss what this implies for the cost of capital, stock market values, and companies' target rates of return. They suggest that many companies are seeking too high a rate of return and thus run the risk of under-investing.

Abstract:
We present and analyze new monthly index series for U.K. financial assets, covering equities, bonds, bills, and inflation. The data are consistent with the CRSP/Ibbotson series for the United States. We use our indices to estimate equity and bond premia and to make international comparisons, especially with the United States, Germany, and Japan. We illustrate potential uses of the new series by investigating stock market seasonality, inflation-linked bonds, real dividend growth rates, and the small-firm effect. While some of our findings resemble U.S results, we also report differences between U.K. and U.S. stock market behavior.

Abstract:
Every finance professional employs the concept of market efficiency. The theory, evidence and counterevidence focus on a couple of dozen highly influential articles published during the twentieth century. We summarise the origins of and interlinkages between these contributions to the history of finance.