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

Author

Listed:
  • 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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    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, 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. Skardziukas, Domantas, 2010. "Practical approach to estimating cost of capital," MPRA Paper 31011, University Library of Munich, Germany.
    4. 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.
    5. Michal Dvořák, 2016. "Measuring Yields: Arithmetic, Geometric and Horizon-Consistent Average," Prague Economic Papers, University of Economics, Prague, vol. 2016(3), pages 335-353.
    6. 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.
    7. Fernandez, Pablo, 2005. "La prima de riesgo del mercado (market risk premium)," IESE Research Papers D/585, IESE Business School.

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