The equity premium puzzle (EPP) describes the unexpectedly high historical outperformance of stocks over Treasury bills that is challenging to justify. The equity risk premium, typically defined as the difference between returns on equities and the returns on Treasury bills, is often estimated to be between 5% and 8% in the United States. This substantial gain is expected to indicate the relative risk of stocks compared to “risk-free” government debt. However, the large discrepancy entailed by this percentage infers an implausibly high level of investor risk aversion.
Key Insights
- The equity premium puzzle (EPP) signifies the significant historical outperformance of stocks over Treasury bills, which remains difficult to elucidate.
- Theoretically, the equity risk premium should be much lower than the historical average of 5% to 8%.
- Theories including prospect theory, the influence of personal debt, the importance of liquidity, the impact of government regulation, and tax considerations have been posed in attempting to address the puzzle.
- Lack of awareness, currency depreciation relative to gold, diversification advantages, and demographic trends may all contribute to understanding the equity premium puzzle.
Unearthing the Equity Premium Puzzle (EPP)
The equity premium puzzle (EPP) was formally introduced in a 1985 study by Rajnish Mehra and Edward C. Prescott, and it remains a conundrum for financial scholars. Professor Edward Prescott even received the Nobel Memorial Prize in Economics in 2004 for his contributions to understanding business cycles, highlighting the societal value of cohesive economic policies.
Many scholars argue that the equity risk premiums observed were too extensive to reflect appropriate compensation for investor risk. Given this context, the premium theoretically should be considerably lower than historical averages between 5% and 8%.
Throughout the 20th century, variation in the equity risk premium estimates is noteworthy. The first half-century estimates hovered around 5%. In contrast, the second half reflected premiums over 8%. Differences in U.S. stock market valuations across decades also provide some insight. For example, valuations were higher in 1900, relatively lower in 1950, and peaked in 2000.
Theoretical Attempts to Solve the Puzzle
Since EPP’s first conceptualization, multiple theories and frameworks have been explored to demystify the equity premium puzzle:
- Prospect Theory by Daniel Kahneman and Amos Tversky suggests behavioral finance concepts could help justify the puzzle by altering assumptions about risk and decision-making.
- Personal Debt and Liquidity discussions examine how leverage and liquidity needs change investor behavior and stock returns.
- Government Regulation and Tax Considerations could influence investment returns by shaping business environments and investor incentives.
Despite various explanations, the lucrative return for stockholders compared to holding “risk-free” Treasury bills remains fundamental.
Special Considerations
There are significant concerns about the persistence of the equity premium given its historical volatility. One argument is investors were unaware of the comparative returns of stocks to other assets. Dividends contributed substantially to stock returns, often overlooked amid daily price movements. Understanding long-term benefits likely helped stock valuation trends increase, possibly leading to reduced future returns and resolving the equity premium puzzle.
Rethinking the ‘Risk-free’ Nature of Treasury Bills
Another key consideration is questioning if Treasury bills are genuinely risk-free. Historical instances of currency inflation and debt defaults by governments indicate otherwise. Measuring performance against gold reveals a less spectacular equity risk premium, suggesting U.S. dollar devaluation rather than extraordinary stock returns might explain high premiums.
Aggregation and Diversification in Investing
The level of risk associated with individual stocks compared to a diverse market portfolio might also clarify the equity risk premium puzzle. Emphasis on diversified investments such as mutual funds and index funds came later, allowing lower risks without compromising returns. Thus, diversification could elucidate the outsized equity risk premium at the puzzle’s core.
Demographics and Stock Market Returns
Demographic trends considerably influencing business growth further address the puzzle. Increasing populations generally bolstered business growth throughout the 20th century. Conversely, stagnating or declining populations resulted in underperforming stock markets in regions like Japan and parts of Europe. Therefore, demographic trends likely contributed to the observed equity premium.
Resolving the equity premium puzzle remains integral to unlocking deeper insights into financial markets and improving investment strategies for future success.
Related Terms: equity risk premium, prospect theory, diversification, mutual funds, index funds, demographics.
