Does inflation exaggerate the equity premium?

Purpose - The aim of this paper is to identify why the historically observed equity risk premium is larger than most researchers believe is reasonable. Whilst equity is undoubtedly riskier than government issued securities, the extent of the realised premium on equity has been characterised as a "puzzle". Design/methodology/approach - This paper measures the equity premium for a number of countries over the past 132 years, and then uses a pooled cross-section and time-series analysis to investigate the relationship between the equity premium and inflation. Findings - This paper shows that the equity premium over the past 132 years has been significantly positively related to the rate of inflation and, therefore, has resulted in an equity premium that is substantially higher in the post 1914 period than before. This effect results from the relative performance of bonds and stocks during inflationary periods. The relatively poor performance of bonds during periods of inflation drives much of the equity premium. Research limitations/implications - Counterfactual simulations in the paper show that the average equity premium post 1914 would have been 4.61 per cent and not 7.34 per cent had the rate of inflation been zero. This is much closer to theoretically derived estimates. Practical implications - The size of the equity premium has implications for investors' asset allocation decision. The importance of inflation suggests that in a low inflation environment, the expected equity premium will be considerably lower than the historically realised equity premium. Originality/value - This paper establishes a clear link between the rate of inflation and the equity premium.