The equity premium is the return earned by a risky security, such as a stock, in excess of that earned by a risk free security, such as a Treasury Bill. It is a crucial input into financial decisions as diverse as asset allocation, capital budgeting and planning for retirement. Historical data provide a wealth of evidence documenting that over long periods of time, stock returns have been considerably higher than the returns for T-bills. The average annual real return (that is, the inflation-adjusted return) on the U.S. stock market for the past 115 years has been about 7.5 percent. In the same period, the real return on a relatively riskless security was a paltry 1.0 percent. The difference between these two returns, 6.5 percentage points, is the equity premium. The dramatic investment implications of these differential rates of return is illustrated below.
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