What Is the Equity Premium Puzzle (EPP)?
Let me explain the equity premium puzzle, or EPP, directly to you: it's about the surprisingly strong historical performance of stocks compared to Treasury bills, and why that's hard to justify. The equity risk premium—basically, stock returns minus Treasury bill returns—sits between 5% and 8% in the US. This premium is meant to compensate for the extra risk in stocks versus supposedly risk-free government securities. But here's the puzzle: this large gap suggests investors are way more risk-averse than makes sense in standard models.
Key Takeaways
- The equity premium puzzle (EPP) points to the hard-to-explain high outperformance of stocks over Treasury bills.
- In theory, this premium should be much lower than the observed 5% to 8% historical average.
- Explanations include prospect theory by Kahneman and Tversky, personal debt, liquidity value, government regulations, and taxes.
- Other factors like past ignorance of returns, dollar decline against gold, diversification, and population growth could resolve the puzzle.
Understanding the Equity Premium Puzzle (EPP)
Rajnish Mehra and Edward Prescott first put this puzzle on paper in 1985, and it's still baffling financial experts today. Prescott even snagged a Nobel in Economics in 2004 for related work on business cycles and policy commitments. Some researchers argue the premium is oversized for what investor risk aversion should demand, so it ought to be lower than that 5% to 8% average we've seen.
The premium hasn't been consistent either—that's part of the enigma. In the first half of the 20th century, it was around 5%, but it jumped over 8% in the second half. Maybe the gold standard kept inflation in check for government bonds back then. Tools like the P/E 10 ratio show stock valuations were high in 1900, low in 1950, and sky-high in 2000, which might explain some shifts.
Since the puzzle emerged, academics have thrown ideas at it: Kahneman and Tversky's prospect theory, how personal debt plays in, the perks of liquidity, regulatory effects, and taxes. No matter the reason, you can't deny investors have profited big from stocks over Treasury bills.
Special Considerations
With all this variability and it being an anomaly, you have to wonder if the equity premium will last. Maybe investors just didn't know how much stocks really returned, especially with dividends hidden behind daily price hype. As awareness grew, valuations rose, which could mean lower future returns and 'solve' the puzzle.
Then there's the 'risk-free' label on Treasury bills—are they really? Governments inflate currencies and default sometimes; even the US isn't immune. Gold might be the true risk-free benchmark. Against gold since 1970, stock premiums look less impressive, blaming the dollar's drop instead of stellar stock gains.
Don't forget about stock aggregation: individual stocks are riskier than the market index. Investors got paid for that specific risk, not broad market risk. Back then, people bought a few stocks directly; diversification via mutual funds and indexes came later. Spreading risk without cutting returns could explain the high premium.
Finally, demographics matter. Businesses grow with more customers from population increases. The 20th century's population boom fueled that, boosting stocks. But in places like Japan or Europe with declining populations, markets suffered. Rising populations might be behind the puzzle all along.
