Maximum likelihood estimation of the equity premium

The equity premium, namely the expected return on the aggregate stock market less the government bill rate, is of central importance to the portfolio allocation of individuals, to the investment decisions of firms, and to model calibration and testing. This quantity is usually estimated from the sample average excess return. We propose an alternative estimator, based on maximum likelihood, that takes into account information contained in dividends and prices. Applied to the postwar sample, our method leads to an economically significant reduction from 6.4% to 5.1%. Simulation results show that our method produces tighter estimates under a range of specifications. ∗Avdis: [email protected]; Wachter: [email protected]. We are grateful to Kenneth Ahern, John Campbell, Ian Dew-Becker, Adlai Fisher, Robert Hall, Soohun Kim, Jonathan Wright, Motohiro Yogo and seminar participants at the University of Alberta, the Wharton School, the NBER Forecasting & Empirical Methods Workshop and the SFS Cavalcade for helpful comments. Maximum likelihood estimation of the equity premium Abstract The equity premium, namely the expected return on the aggregate stock market less the government bill rate, is of central importance to the portfolio allocation of individuals, to the investment decisions of firms, and to model calibration and testing. This quantity is usually estimated from the sample average excess return. We propose an alternative estimator, based on maximum likelihood, that takes into account information contained in dividends and prices. Applied to the postwar sample, our method leads to an economically significant reduction from 6.4% to 5.1%. Simulation results show that our method produces tighter estimates under a range of specifications.The equity premium, namely the expected return on the aggregate stock market less the government bill rate, is of central importance to the portfolio allocation of individuals, to the investment decisions of firms, and to model calibration and testing. This quantity is usually estimated from the sample average excess return. We propose an alternative estimator, based on maximum likelihood, that takes into account information contained in dividends and prices. Applied to the postwar sample, our method leads to an economically significant reduction from 6.4% to 5.1%. Simulation results show that our method produces tighter estimates under a range of specifications.