Equity premium puzzle

The equity premium puzzle is a term coined by economists Rajnish Mehra and Edward C. Prescott. It is based on the observation that in order to reconcile the much higher return on equity stock 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 led 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" - the risk premium (in fact the historical outperformance) on equity in stocks vs. government bonds - over the past century was approximately 6% per annum. However, over any one decade, the outperformance had great variability - from over 19% in the 1950s to 0.3% in the 1970s. 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 if these figures represented the "expected" outperformance of equities over bonds, investors would have to be indifferent between a bet equally likely to pay $50,000 or $100,000 (an expected value of $75,000) and a certain payoff of $51,209 (Benartzi and Thaler, 1995).

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), Mehra and Prescott (2003) present a detailed analysis of these explanations in financial markets and conclude that the puzzle is real and remains unexplained. Subsequent reviews of the literature have similarly found no agreed resolution.

Grant and Quiggin (2006) distinguish several classes of explanation of the puzzle.

Individual characteristics

Some explanations rely on assumptions about individual behavior and preferences different from those made by Mehra and Prescott. Examples include the prospect theory model of Benartzi and Thaler (1995) based on loss aversion. A problem for this model is the lack of a general model of portfolio choice and asset valuation for prospect theory.

A second class of explanations is based on relaxation of the optimization assumptions of the standard model. The standard model represents consumers as continuously-optimizing dynamically-consistent expected-utility maximizers. These assumptions provide a tight link between attitudes to risk and attitudes to variations in intertemporal consumption which is crucial in deriving the equity premium puzzle. Solutions of this kind work by weakening the assumption of continuous optimization, for example by supposing that consumers adopt satisficing rules rather than optimizing. An example is "info-gap decision theory" (Ben-Haim, 2006), based on a non-probabilistic treatment of uncertainty, which leads to the adoption of a robust satisficing approach to asset allocation.

Equity characteristics

A second class of explanations focuses on characteristics of equity not captured by standard capital market models, but nonetheless consistent with rational optimization by investors in smoothly functioning markets. Writers including Bansal and Coleman (1996), Palomino (1996) and Holmstrom and Tirole (1998) focus on the demand for liquidity.

Tax distortions

McGrattan and Prescott (2001) argue that the observed equity premium in the United States since 1945 may be explained by changes in the tax treatment of interest and dividend income. As Mehra (2003) notes, there are some difficulties in the calibration used in this analysis and the existence of a substantial equity premium before 1945 is left unexplained.

Market failure explanations

Two broad classes of market failure have been considered as explanations of the equity premium. First, problems of adverse selection and moral hazard may result in the absence of markets in which individuals can insure themselves against systematic risk in labor income and noncorporate profits. Second, transactions costs or liquidity constraints may prevent individuals from smoothing consumption over time.

Implied volatility

Graham and Harvey [The Equity Risk Premium in January 2007:Evidence from the Global CFO Outlook Survey, John R. Graham,Campbell R. Harvey] have estimated that for the United States, the expected average premium during June 2000 to Nov. 2006 has ranged between 4.65 to 2.50. They found a modest correlation of 0.62 between the 10-year equity premium and a measure of implied volatility (in this case, VIX, the Chicago Board Options Exchange Volatility Index).

Other explanations

Arguably more likely explanations are:

*Over the period, the observed outperformance of equities was substantially in excess of market expectations at the beginning of the relevant periods. This is not altogether surprising in view of the variability referred to above.
*Part of the reason for investment in fixed interest bonds was that much the liabilities of insurance companies and pension funds requiring to be matched were expressed as guarantees of fixed currency amounts.

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

ee also

* Ellsberg paradox
* Loss aversion
* Risk aversion
* List of cognitive biases
* Economic puzzle

References

* cite journal
last = Mehra
first = Rajnish
coauthors = Edward C. Prescott
title = The Equity Premium: A Puzzle
journal = Journal of Monetary Economics
volume = 15
pages = 145–161
date = 1985
url = http://www.academicwebpages.com/preview/mehra/pdf/The%20Equity%20Premium%20A%20Puzzle.pdf
doi = 10.1016/0304-3932(85)90061-3
* cite journal
last = Kocherlakota
first = Narayana R.
title = The Equity Premium: It's Still a Puzzle
journal = Journal of Economic Literature
volume = 34
issue = 1
pages = 42–71
date = March 1996
url = http://www.econ.ucdavis.edu/faculty/kdsalyer/LECTURES/Ecn200e/Kocherla.pdf
* cite book
last = Mehra
first = Rajnish
coauthors = Edward C. Prescott
editor = G.M. Constantinides, M. Harris and R. Stulz
chapter = The Equity Premium Puzzle in Retrospect
title = Handbook of the Economics of Finance
year = 2003
publisher = North Holland
location = Amsterdam
pages = 889-938
isbn = 978-0-444-51363-2
chapterurl = http://www.academicwebpages.com/preview/mehra/pdf/epp_retrospect.pdf
* cite journal
last = Benartzi
first = Shlomo
coauthors = Richard H. Thaler
title = Myopic Loss Aversion and the Equity Premium Puzzle
journal = The Quarterly Journal of Economics
volume = 110
issue = 1
pages = 73–92
date = Feb. 1995
url = http://ideas.repec.org/a/tpr/qjecon/v110y1995i1p73-92.html
doi = 10.2307/2118511 (subscription required to download paper)
* Yakov Ben-Haim, "Info-Gap Decision Theory: Decisions Under Severe Uncertainty," Academic Press, 2nd edition, Sep. 2006. ISBN 0-12-373552-1.
* Grant, S. and Quiggin, J. (2006), "The risk premium for equity: implications for resource allocation, welfare and policy," Australian Economic Papers, 45(3), 253–68. [http://www.blackwell-synergy.com/doi/abs/10.1111/j.1467-8454.2006.00291.x]