Search Investopedia

Equity Premium Puzzle - EPP

Filed Under » , ,
Dictionary Says

Definition of '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. 
Investopedia Says

Investopedia explains '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.

Related Definitions

  •

    Gambler's Fallacy

    When an individual erroneously believes that the onset of a certain random event is less likely to happen following an event or a series of events. This line of thinking is incorrect ...
    Read More »

  • Real Rate Of Return

    The annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects. This method expresses the nominal rate of ...
    Read More »

  • Expected Return

    The average of a probability distribution of possible returns, calculated by using the following formula:
    Read More »

    • Capital Asset Pricing Model - CAPM

      A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. The general idea behind CAPM is that investors need to be ...
      Read More »

    • Risk-Free Rate Of Return

      The theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a ...
      Read More »

    • Risk-Return Tradeoff

      The principle that potential return rises with an increase in risk. Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty ...
      Read More »

    • Risk Averse

      A description of an investor who, when faced with two investments with a similar expected return (but different risks), will prefer the one with the lower risk.
      Read More »

    • Equity Risk Premium

      The excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk ...
      Read More »

    • Consumption Capital Asset Pricing Model - CCAPM

      A financial model that extends the concepts of the capital asset pricing model (CAPM) to include the amount that an individual or firm wishes to consume in the future. The CCAPM uses ...
      Read More »

    • Risk-Free Rate Puzzle - RFRP

      An anomaly in the difference between the lower historic real returns of government bonds compared to equities. This puzzle is the inverse of the equity premium puzzle, and looks at the ...
      Read More »

Articles Of Interest

Sponsored links
Hot Definitions
Partner Links
Suggested Definitions