Irrational Optimism

No doubt many of you (myself included) will dutifully report to our students that the historical average return for large stocks is about 12% which corresponds to a risk premium of around 8%. (keeping math simple 😉 (see virtually any investment text for these numbers)) However, Dimson, Marsh, and Staunton report that this is probably an overly optimistic number. Not because the expected equity risk premium is expected to fall in the future because the market is currently overvalued as those in the Campbell-Schiller camp believe (although it may be), but because we are not looking at the right historical returns! So what is wrong? Virtually every finance text book dutifully reports US equity returns from 1926 to the present. However, this is a period where the US stock market was a very strong performer. Dimson, Marsh, and Staunton do two things to adjust for this: 1. they go back further–to 1926 and 2. they look at global returns and not just US returns. Their findings? Stocks have had lower returns and higher risks. [FinanceProfessor.com Annotation]