Equity Premium Puzzle (EPP)

What Is the Equity Premium Puzzle (EPP)?

The equity premium puzzle (EPP) refers to the excessively high historical outperformance of stocks over Treasury bills, which is challenging to explain. The equity risk premium, which is normally defined as equity returns minus the return of Treasury bills, is estimated to be between 5% and 8% in the United States. The premium is supposed to reflect the relative risk of stocks compared to "risk-free" government securities. However, the puzzle arises because this unexpectedly large percentage implies an unreasonably high level of risk aversion among investors.

Understanding the Equity Premium Puzzle (EPP)

The equity premium puzzle (EPP) was first formalized in a study by Rajnish Mehra and Edward C. Prescott in 1985. It remains a mystery to financial academics right up 'til now. Eminently, Professor Prescott won the Nobel Memorial Prize in Economics in 2004 for his work on business cycles and demonstrating that "society could gain from a prior commitment to economic policy," as per a statement by the prize organization.

Some academics believe the equity risk premium is too large to reflect a "proper" level of compensation that would result from investor risk aversion. Therefore, the premium ought to really be a lot of lower than the historical average of between 5% and 8%.

Some of the mystery encompassing the equity premium puzzle involves the variance of the premium over time. Estimates for the principal half of the twentieth century put the equity risk premium at near 5%. In the second half of that century, the equity premium went up to over 8%. The equity premium for the principal half might be lower because the U.S. was still on the gold standard, restricting the impact of inflation on government securities. Many measures of stock market valuation, like the P/E 10 ratio, additionally help to explain the different equity premiums. U.S. stock valuations were above average in 1900, relatively low in 1950, and at record highs in 2000.

Since the presentation of the EPP, numerous academics attempted to solve, or if nothing else partly explain, the equity premium puzzle. The prospect theory by Daniel Kahneman and Amos Tversky, the role of personal debt, the value of liquidity, the impact of government regulation, and tax considerations have been applied to the puzzle.

Regardless of the explanation, the reality remains that investors have been rewarded handsomely for holding stocks instead of "risk-free" Treasury bills.

Special Considerations

Given its variance and status as an anomaly, there are substantial questions about the solidness of the equity premium. Perhaps, the real reason for the seemingly excessive equity risk premium is that investors didn't realize the amount more stocks returned. A large portion of the market's returns come from dividends, which are obscured by media coverage of daily price movements. As people realized the long-term benefits of stock ownership, valuation levels generally trended up. The end result could be lower returns for stocks, which would solve the equity premium puzzle.

The "risk-free" nature and value of Treasury bills is another pivotal consideration. Are Treasury bills genuinely risk-free? Of course not. Numerous governments have inflated their currencies and defaulted on their debts. Even the credibility of the U.S. government varies over time. Ostensibly, gold is the risk-free asset. Measured against gold, the equity premium since 1970 is undeniably less impressive. Starting here of view, the high equity premium is explained by the decline of the U.S. dollar against gold rather than objectively high returns for stocks.

The aggregation of stocks may likewise play a part in the equity risk premium puzzle. Individual stocks are far riskier than the stock market as a whole. As a rule, investors were compensated for the higher risk of holding particular stocks rather than overall market risk. The traditional idea was that an investor would directly buy shares in a few companies. Ideas about diversification, mutual funds, and index funds came later. By diversifying, investors can reduce risk without reducing returns, potentially explaining the excessive equity risk premium at the heart of the equity premium puzzle.

At long last, demographics may play a huge role in stock market returns and explaining the equity premium puzzle. Intuitively, businesses need more customers to develop. When the population is rising, the average business consequently gets new customers and develops. During the twentieth century, populations in many countries were increasing, which supported business growth and higher stock market returns. Empirically, stock markets in Japan and numerous European countries performed poorly as their populations started to decline. Perhaps, rising populations created the equity premium puzzle.

Highlights

• Previous lack of knowledge, the decline of the U.S. dollar relative to gold, the benefits of diversification, and population growth are possible answers for the equity premium puzzle.
• Theoretically, the premium ought to really be a lot of lower than the historical average of between 5% and 8%.
• The equity premium puzzle (EPP) refers to the excessively high historical outperformance of stocks over Treasury bills, which is challenging to explain.
• The prospect theory by Daniel Kahneman and Amos Tversky, the role of personal debt, the importance of liquidity, the impact of government regulation, and tax considerations have been applied to the puzzle.