Equity Premium Puzzle - EPP

What is an 'Equity Premium Puzzle - EPP'

An phenomenon that describes the anomalously higher historical real returns of stocks over government bonds. The equity premium, which is defined as equity returns less bond returns, has been about 6% on average for the past century. It is supposed to reflect the relative risk of stocks compared to "risk-free" government bonds, but the puzzle arises because this unexpectedly large percentage implies a suspiciously high level of risk aversion among investors.

BREAKING DOWN 'Equity Premium Puzzle - EPP'

The equity premium puzzle is a mystery to financial academics. According to some academics, the difference is too large to reflect a "proper" level of compensation that would occur as a result of investor risk aversion; therefore, the premium should actually be much lower than the historic average of 6%.

More recent extensions to the puzzle attempt to offer a different rationale for explaining the EPP, such as investor prospects and macroeconomic influences. No matter the explanation, the fact remains that investors are being rewarded very well for holding equity compared to government bonds.

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RELATED FAQS
  1. What is the historical market risk premium?

    Learn what the historical market risk premium is and the different figures that result from an analyst's choice of calculations ... Read Answer >>
  2. Is the market risk premium the same for stocks and bonds?

    Take a look at historical equity risk premium and credit spreads in the United States, which suggest that equities carry ... Read Answer >>
  3. What are the benefits of government bonds?

    Its true for the fact that it is one of the safest instruments to invest, but do you really get the rate of return over a ... Read Answer >>
  4. What does a high equity risk premium signify about a company's stock future?

    Learn about how a high equity risk premium affects a stock's future. These types of stocks tend to be the most volatile instruments ... Read Answer >>
  5. Is market risk premium the same for all investors and investments?

    Learn about how market risk premiums are determined, how they are calculated, why some assets require higher premiums and ... Read Answer >>
  6. How accurate is the equity risk premium in evaluating a stock?

    Learn about the drawbacks of using the equity risk premium to evaluate a stock, and understand how it is calculated using ... Read Answer >>
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