Luck and the US Equity Premium

Abstract

The equity premium puzzle in US stocks is resolved by a simple model for luck across countries. The observed premium of the US and other successful countries are positively biased since they are implicitly conditioned on being the largest observations over a period of history. After correcting this bias effect ("winner bias"), the observed US equity premium is consistent with an ex-ante premium of zero. A simple model is used where the return on every global market has equal mean and variance, and equal ex-ante equity premium of zero. It is tested against long-term equity returns for 39 countries over 50 years. The model correctly predicts the winning country's ex-post premia and Sharpe ratio with US values; the distribution of all countries ex-post premia and the distribution of market capitalizations. This suggests the US premium is significantly lower than long-term historical estimates and luck is a sufficient explanation for long-term differences in countries equity markets.

Keywords: Selection Bias, Equity premium, order statistics

JEL Classification: G10, G12, G15