The risk return tradeoff in the long run: 1836-2003

Previous studies typically find a statistically insignificant relation 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. Indexes of United States stock prices from 1802 to 1987. Journal of Business 63, 399-426], 1 estimate a positive and statistically significant risk return tradeoff. Finally, exploratory analysis suggests a role for a time-varying relation linked to the changing nature of the U.S. economy. (c) 2007 Elsevier B.V. All rights reserved.