The equity premium puzzle refers to the phenomenon that observed average annual returns on stocks over the past century are higher, by approximately 6 percentage points, than returns on government bonds. Economists expect arbitrage opportunities would reduce the difference between returns on these two investment opportunities to reflect the risk premium investors demand when investing in relatively more risky stocks. The puzzle arises as the observed difference in returns implies an implausibly high level of risk aversion. That is, economists predict the difference in returns between these two investments should be much smaller than 6 percentage points. To quantify the level of risk aversion implied, investors would have to be indifferent between a bet with a 50 percent chance of $50,000 or $100,000 and a certain payoff of $51,209.

A large number of explanations for the puzzle have been proposed. These include a contention that the puzzle is a statistical illusion, modifications to the assumed preferences of investors and imperfections. Kocherlakota (1996) presents a detailed analysis of these explanations in financial markets and concludes that the puzzle is real and remains unexplained. Subsequent reviews of the literature have similarly found no agreed resolution.

An alternative explanation for the puzzle has been proposed by Benartzi and Thaler (1995). Applying prospect theory they contend that myopic loss aversion provides a plausible solution to the puzzle. They assert that investors evaluate their portfolio in a relatively short sighted way and that, as loss aversion implies, they are highly sensitive to losses over this time period. The evaluation time period implied in their model by an equity premium of 6 percentage points and a 2x loss aversion multiplier (a general finding of loss aversion research) is approximately one year. This explanation does seem consistent with the data and has not, to date, been rebutted. However, in the absence of a general model of portfolio choice and asset valuation for prospect theory it has not received general acceptance.

The magnitude of the equity premium has implications for resource allocation, social welfare, and economic policy. Grant and Quiggin (2005) derive the following implications of the existence of a large equity premium:

• That the macroeconomic variability associated with recessions is very expensive

• That risk to corporate profits robs the stock market of most of its value

• That corporate executives are under irresistible pressure to make short-sighted, myopic decisions

• That policies—disinflation, costly reform—that promise long-term gains at the expense of short-term pain are much less attractive if their benefits are risky

• That social insurance programs might well benefit from investing their resources in risky portfolios in order to mobilize additional risk-bearing capacity

• That there is a strong case for public investment in long-term projects and corporations, and for policies to reduce the cost of risky capital

• That transaction taxes could be either for good or for ill

References

• Narayana R. Kocherlakota, 'The Equity Premium: It's Still a Puzzle' Journal of Economic Literature, Vol. 34, No. 1. (Mar., 1996), pp. 42-7
• Shlomo Benartzi; Richard H. Thaler 'Myopic Loss Aversion and the Equity Premium Puzzle' The Quarterly Journal of Economics, Vol. 110, No. 1. (Feb., 1995), pp. 73-92 ^* (JSTOR subscription required)
• Mehra, Rajnish, and Edward C.Prescott. 'The Equity Premium: A Puzzle' Journal Monetary Economics 15 (1985), pp. 145–161.
• Grant, Simon and Quiggin, John 'What Does the Equity Premium Mean?', The Economists' Voice 2(4), ^* (subscription required)

Stock market | Finance theories | Behavioral Finance | Economics of uncertainty

Equity premium puzzle