Equity Premium Puzzle

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Equity Premium Puzzle

Introduction

Equity Premium Puzzle is a phenomenon that explains the abnormalities experienced in high stock returns over the government bonds. For instance, suppose a granddad had some money lying around in the year 1960 and decided to bequeath his granddaughter $1000 upon anticipating her bath. He decided to invest the money by buying government bonds and by the year 1999 the bonds were $12,270. On the other hand, if he had invested in a portfolio of stocks he could be having $742,000 by the year 1999. Therefore, it is vivid that the difference in returns is extremely large.

Equity premium, therefore, is the difference in return on stocks and return on government bonds. Since equity premium is too large to be explained using standard economic models, it is, therefore, referred to as Equity Premium Puzzle.

The Puzzle

In essence, stocks are known to have a higher risk compared to government bonds thus they should earn higher returns. Standard general equilibrium model can be used to determine whether the equity premium is too big. In this model, ones utility of consumption is independent of every year, i.e. utility consumption of this year does not depend on the other years. Consequently, people tend to have different utility functions and constant relative risk aversion.

Coefficient of relative risk aversion (A) is the only parameter in this model. The interpretation of A is such that whenever consumption goes down by one percent, marginal value of a dollar of income goes up by A percent. Therefore, the puzzling part of it is that, which value of the coefficient of relative risk aversion is needed to explain the antique equity premium? The Equity Premium Puzzle has been a mystery to financial academics. Some academics consider the difference to be too large even to portray the right level of compensation.  Financial academics worked out the puzzle and found out that the value of A would be between 30-40, which was not reasonable since it was too high as per to their conclusion. According to them, the premium needs to be lower than the antique average of six percent.

It is evident that a high value of A implies that people would want smooth consumption desperately overtime since a downfall in consumption is much worse than surpluses. Therefore, in order for one to live a better life, he or she needs to borrow from the richer future since the economy has a trend of becoming richer overtime. However, people are advised to borrow with a common interest that would lead to high real rate of interest. In the recent years, the real rate of interest has been barely positive over a long time. Thus, the Equity Premium Puzzle may as well be referred to as a low risk-free rate puzzle.

In conclusion, when one is explaining the Equity Premium Puzzle he or she needs to determine the factors that need adjustment to the empirical side of the puzzle[1]. For instance, uncovering data that would make equity premium much smaller or equity returns much riskier. Theoretical framework may as well be explored in explaining the Equity Premium Puzzle, such as the influence of microeconomics and the investor prospects. Therefore, regardless of the explanation, the bottom truth is that investors are earning more for holding equity than government bonds.

 

References

Siegel, Jeremy J. and Richard H. Thaler. “Anomalies: The Equity Premium Puzzle.” (1997) Vol.

11 No. 1 The Journal of Economic Perspectives 191-200.

[1] Siegel, Jeremy J. and Richard H. Thaler. “Anomalies: The Equity Premium Puzzle.” (1997) Vol. 11 No. 1 The Journal of Economic Perspectives 191-200.

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