The Shrinking Equity Premium and What It Means to Investors

by Paula Hogan

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In every walk of life, there are periodic debates about norms, from physicists deciding how the universe began to parents debating how to get an infant to sleep through the night. These debates help form our notion of what is correct and normal and lay the foundation for our perception of what to expect in the future.

Financial economists—the academics who study financial markets and human investment behavior and who in large part form our notion of what is normal in the world of investments—are now engaged in such a debate, a debate that is beginning to be covered in the popular press. Consequently we may be in the midst of a cultural change in our notion of what is normal in the world of investments.

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The debate centers on the estimate of the equity premium, which measures the excess return of stocks over the return offered by risk-free assets—how much higher a return we may expect, on average, from stocks than from U.S. Treasuries. In other words, it measures the compensation for the risk of being an owner.

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