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12 September 2017 Financial Analysts Journal Book Review

The Equity Risk Premium: Essays and Explorations (A review)

  1. Mark S. Rzepczynski
Two leading researchers in the field have collected their essays on the equity risk premium and present them with unifying, well-written background material.

Why the equity risk premium is so large relative to what theory predicts is one of the most important questions in finance and possibly one of the main controversies that CFA charterholders need to study. William Goetzmann and Roger Ibbotson are two leading researchers on the equity risk premium whose empirical work has invaluably enriched the literature. This book of essays pulls together their research on the topic, which has spanned decades. The authors provide not only a collection of articles but also background and context for their papers and for the key research issues, and they achieve cohesiveness through a strong introduction and lucid sectional overviews.

Five sections address distinct themes. The first focuses on the lessons of history and describes the measurement of the equity premium over long time periods. Sections 2 and 3 discuss the building blocks of models designed to forecast future premiums. The section on survivorship and selection bias develops the important theme of measurement when information is available only on those markets that have stood the test of time. Survivorship may be the key to explaining why premiums are high. The final section deals with issues of predicting variations in the equity premium.

Goetzmann and Ibbotson examine in detail the established methodologies for measuring historical equity premiums. This review is essential to understanding risk premiums because the only way to determine whether current equity premiums are normal is to broaden the dataset on returns, either by analyzing more markets or by forming a longer time frame. In this historical section, the authors capably summarize the behavior of U.S. equity returns back to 1815. The reader can easily see that a vast amount of painstaking work was required to expand the historical record.

The methodological review also supplies information on U.S. and world wealth, which is essential for identifying the true market portfolio. It is this detailed historical work that formed the basis for Ibbotson’s successful business. Without it, wealth management advisory work would not have reached its present state of development. Much of the current wisdom on asset allocation, such as buying stock for the long run, is based on Ibbotson’s data. Using tables that are included in the book, the reader can review the historical record for core asset classes.

After getting a handle on the historical returns, the next step is to explore what drives the equity premium. The authors present a building-block approach to calculating the risk premium. They also discuss the alternatives of determining the premium based on investors’ risk factors (the demand side) and discounting earnings or cash flows (the supply side). A problem with this section is that alternative approaches to generating risk premiums provide very different answers and are sensitive to the assumptions used. Acknowledging and exploring these differences, so the reader could judge which alternatives are the best, would have been useful.

The simulation and forecasting section provides research on estimating future equity risk premiums. A surprise in this discussion is how well some of the early simulations have performed in forecasting for the very long run. Simple rules, it turns out, do work, and several straightforward, practical approaches to forecasting have not been improved upon significantly in the past 25 years. The pioneering methods described can be effectively used today to provide good working estimates for long-term asset allocation.

Goetzmann and Ibbotson’s work on historical equity premiums opened up a whole new line of research into survivorship and selection bias. Returns are available only on those markets that have survived over the long run. Crises and extreme events that destroyed equity markets are often not included in the data, which results in a clear upward bias in the record of equity market performance. Although survivorship and selection bias cannot explain the entire equity premium puzzle, this aspect of the authors’ research has important implications beyond the equity premium topic.

The section on predicting variations in the equity risk premium indicates that little progress has been made despite extensive work on the problem. For example, contrary to the results of others who have studied the question, Goetzmann and Ibbotson suggest that dividend yield may not be a good predictor of future premiums. Data limitations cause the findings on this critical topic to be confusing.

Books of essays are generally problematic. The quality of the work is invariably uneven and subject to redundancies. Some research is simply outdated and not useful for most readers in its original form. A major disappointment of The Equity Risk Premium: Essays and Explorations is the limited review of research by others, several of whom have made significant contributions. Goetzmann and Ibbotson cite many other works, and several of the papers in this volume have coauthors, but this book does not constitute a complete review of the equity risk premium puzzle.

Given the quality of the authors’ previous work, I expected a deeper interpretation of the overall puzzle of the equity premium than the short introduction this book provides. The book’s focus is on empirical issues at the expense of theoretical explanations of the equity risk premium. Many excellent researchers have offered innovative explanations of the puzzle, and a Goetzmann–Ibbotson critique of these results would have been insightful. Nevertheless, The Equity Risk Premium is a useful addition to the literature, partly because few alternatives for obtaining information on the topic are available in one book.1


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