The Equity Premium Puzzle

The Equity Premium

A decades-old mystery that has plagued economists and left them scratching their heads and scrambling for theories… sounds intriguing? Let’s dive into the perplexing puzzle of the equity premium.
If you look at the historical returns from US stocks and US Treasury bonds over the last century, you’ll find that returns on stocks are much higher than those on bonds. The difference between these two is called the equity premium, i.e.,

Equity Premium = Equity Returns – Bond Returns

Historically, Treasury bonds have given returns of about 1% and equity of about 7-8%. The equity premium comes out to be around 6-7%.

So why does this premium exist? Why does equity consistently outperform bonds? Let’s take a moment to recall the meaning of Treasury bonds. Treasury bonds are government securities, and typically, the government is not expected to default. So these bonds are considered risk-free securities. Stocks, on the other hand, are pretty volatile or risky.

In finance and investment, a core principle is that the higher the risk, the higher the potential reward. Reasonably intuitive, right? You wouldn’t take a chance if there weren’t high stakes. This is commonly known as the risk-return tradeoff. Since equity stocks are riskier securities, they provide higher returns.

What’s the Puzzle, then?

The puzzling part is the magnitude of the equity premium. Considering reasonable levels of risk aversion for which the investor has to be compensated, most academics calculate the expected premium to be less than 1%. But we’ve seen that the actual equity premium has been about 6% over a century. And this extraordinary difference is the puzzle that still has financial academics in a twist.

Many solutions have been proposed and rejected, and many others are still being debated. One famous theory stemming from behavioral finance is something called myopic loss aversion. It states that investors are more risk-averse in shorter periods, and the observed premium makes sense if investments were considered to be over a time horizon of about one year, which isn’t very unreasonable to assume. But no theory so far has found general acceptance.

The puzzle is not merely an insignificant oddity; explaining the difference between the expected and observed premiums could go a long way in furthering our understanding and improving our models and has implications in related fields like policy and welfare. Solving the equity premium puzzle may help us unlock other mysteries.