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Biases in Arithmetic and Geometric Averages as Estimates of Long-Run Expected Returns and Risk Premia

Author

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  • Daniel C. Indro
  • Wayne Y. Lee

Abstract

In considering a long-term investment in a common stock, an investor wants an estimate of the stock's long-run risk premia (and thus the long-run expected returns). Similarly, in evaluating a capital investment project, a firm seeks a reliable estimate of the required return on the proposed project. Given the empirical evidence of mean reversion in long-horizon common stock returns, we find that sample estimates based on the arithmetic or geometric averages of the past returns are biased.

Suggested Citation

  • Daniel C. Indro & Wayne Y. Lee, 1997. "Biases in Arithmetic and Geometric Averages as Estimates of Long-Run Expected Returns and Risk Premia," Financial Management, Financial Management Association, vol. 26(4), Winter.
    • Handle: RePEc:fma:fmanag:indro97
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    Citations

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    Cited by:

    1. Alan Gregory, 2011. "The Expected Cost of Equity and the Expected Risk Premium in the UK," Review of Behavioral Finance, Emerald Group Publishing Limited, vol. 3(1), pages 1-26, April.
    2. Wolfgang Bessler, 1999. "Equity returns, bond returns, and the equity premium in the German capital market," The European Journal of Finance, Taylor & Francis Journals, vol. 5(3), pages 186-201.
    3. Edward McLaney & John Pointon & Melanie Thomas & Jon Tucker, 2004. "Practitioners' perspectives on the UK cost of capital," The European Journal of Finance, Taylor & Francis Journals, vol. 10(2), pages 123-138.
    4. Skardziukas, Domantas, 2010. "Practical approach to estimating cost of capital," MPRA Paper 31011, University Library of Munich, Germany.
    5. Shin, Hyun-Han & Soenen, Luc, 1999. "Exposure to currency risk by US multinational corporations," Journal of Multinational Financial Management, Elsevier, vol. 9(2), pages 195-207, March.
    6. Michal Dvořák, 2016. "Measuring Yields: Arithmetic, Geometric and Horizon-Consistent Average," Prague Economic Papers, Prague University of Economics and Business, vol. 2016(3), pages 335-353.
    7. Enzo Busseti, 2019. "Risk and Return models for Equity Markets and Implied Equity Risk Premium," Papers 1903.07737, arXiv.org.
    8. Christoph Kaserer, 2022. "Estimating the market risk premium for valuations: arithmetic or geometric mean or something in between?," Journal of Business Economics, Springer, vol. 92(8), pages 1373-1415, October.
    9. Freeman, Mark C., 2009. "Yes, we should discount the far-distant future at its lowest possible rate: a resolution of the Weitzman-Gollier puzzle," Economics Discussion Papers 2009-42, Kiel Institute for the World Economy (IfW Kiel).
    10. Mark Freeman & Ben Groom, 2015. "Using equity premium survey data to estimate future wealth," Review of Quantitative Finance and Accounting, Springer, vol. 45(4), pages 665-693, November.
    11. Freeman, Mark C., 2010. "Yes, we should discount the far-distant future at its lowest possible rate: A resolution of the Weitzman-Gollier puzzle," Economics - The Open-Access, Open-Assessment E-Journal (2007-2020), Kiel Institute for the World Economy (IfW Kiel), vol. 4, pages 1-21.
    12. Fernandez, Pablo, 2005. "La prima de riesgo del mercado (market risk premium)," IESE Research Papers D/585, IESE Business School.

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