The Risk Return Tradeoff in the Long-Run: 1836-2003

Previous studies typically find a statistically insignificant relationship between the market risk premium and its expected volatility. Further, several of these studies estimate a negative risk return tradeoff contrary to the predictions of mainstream theory. Using simulations, I demonstrate that even 100 years of data constitute a small sample that may easily lead to this finding even though the true risk return tradeoff is positive. Small sample inference is plagued by the fact that conditional volatility has almost no explanatory power for realized returns. Using the nearly two century history of U.S. equity market returns from Schwert (1990), I estimate a positive and statistically significant risk return tradeoff across every specification considered. Finally, exploratory analysis suggests a role for a time-varying risk return tradeoff linked to the changing nature of the U.S. markets and economy over the historical record. JEL Classification: G12, C22, C15