DRAFT: Why Have Superhigh Long-Run Stock Returns in America Persisted?
Suppose that you had started in January 1871 and had invested your wealth in the stock market—in a broadly diversified set of common stocks. Suppose that, as dividends rolled in, you had reinvested them in your portfolio. Suppose that every January you had rebalanced—sold winners and bought losers so as to maintain your diversification. Suppose that you had paid no taxes, and had incurred no transaction costs. Then, for Robert Shiller's version of a diversified stock portfolio, and adjusted for inflation, as of last January you would have 65,004 times your initial wealth investment. By contrast, if you had performed the same portfolio investment experiment, but with long-term U.S. Treasury bonds, you would have 41 times your initial wealth. 65004 to 41. An average geometric real return for stocks of 7.3% per year, and for long bonds of 2.5% per year: an average gap of 4.8%-points per year. This is the "equity premium puzzle" of Rajneesh Mehta and Edward Prescott.