Equity premium puzzle

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The equity premium puzzle is a term coined by economists Rajnish Mehra and Edward Prescott in 1985. It is based on the observation that in order to reconcile the much higher return on stocks compared to government bonds in the United States, individuals must have implausibly high risk aversion according to standard economics models. Similar situations prevail in many other industrialized countries. The puzzle has lead to an extensive research effort in both macroeconomics and finance. So far a range of useful theoretical tools and several plausible explanations have been presented, but a solution generally accepted by the economics profession remains elusive.

In the United States, the observed equity premium, or more precisely the risk premium for equity, over the past century is approximately 6 percentage points. It is this gap that is much larger than would be predicted on the basis of standard models of financial markets and assumptions about risk attitudes. 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 (Benartzi and Thaler, 1995).

[edit] Possible explanations

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.

Yet another explanation of the equity premium puzzle is based on info-gap decision theory (Ben-Haim, 2006). The crux of the matter is the non-probabilistic treatment of uncertainty. The info-gap formulation presumes that the investor knows the past returns, believes that future returns may deviate greatly from past experience, and that reliable probabilistic models of these deviations are unavailable. The challenge facing investors is to decide whether adequate returns are sufficiently reliable. If not, then the resources can be invested elsewhere. We model this behavior by assuming that investors choose the investment so as to satisfice the utility (i.e., achieve a certain minimum level of utility) and maximize the robustness against uncertainty in the future returns, rather than to maximize the total discounted utility. This leads to generalizations of the Lucas asset pricing relations. One finds three properties. First, the investor's robustness to uncertainty decreases as the aspiration for profit increases. Second, the robustness is zero for a profit-maximizer. Third, the equity premium is proportional to the investor's robustness. These three properties explain why asset pricing models based on profit-maximization lead to the equity premium puzzle: maximizers have zero robustness and hence zero equity premium even for enormous risk aversion. Furthermore, info-gap robust-satisficing is numerically consistent with the observed equity premium, consumption growth, and low Arrow-Pratt risk aversion (Ben-Haim, 2006, section 11.5).

[edit] Implications

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

[edit] References

Kocherlakota, Narayana R. (March 1996). "The Equity Premium: It's Still a Puzzle". Journal of Economic Literature 34 (1): 42-71.
Benartzi, Shlomo, Richard H. Thaler (Feb. 1995). "Myopic Loss Aversion and the Equity Premium Puzzle". The Quarterly Journal of Economics 110 (1): 73-92. (subscription required to download paper)
Mehra, Rajnish, Edward C. Prescott (1985). "The Equity Premium: A Puzzle". Journal of Monetary Economics 15: 145-161.
Grant, Simon, John Quiggin (2005). "What Does the Equity Premium Mean?". The Economists' Voice 2 (4). (subscription required to download paper)
Ben-Haim, Yakov (2006). Info-Gap Decision Theory: Decisions Under Severe Uncertainty. London: Academic Press.