What Is the Equity Premium Puzzle (EPP)?
The equity premium puzzle (EPP) is a phenomenon that describes the anomalously higher historical real returns of stocks over government bonds. The equity premium, which is defined as equity returns minus bond returns, has been approximately 6.4% on average over a 100+ year period in the U.S. The premium 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 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 to this day. 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 6.4%. The puzzle is not confined to the U.S. — the U.K. has had excess equity returns of over 6% as well, and investors in Japan, Germany, and France have enjoyed equity premiums of over 9%.
Since the introduction of the EPP many attempts to solve, or at least partly explain, the puzzle have taken place in academia. The prospect theory by Daniel Kahneman and Amos Tversky, the role of personal debt, the importance of liquidity, the impact of government regulation and consideration of taxes — these and other elements have been applied to the puzzle in an attempt to explain the high premium. No matter the explanation, the fact remains that investors have been rewarded handsomely for holding stocks instead of government bonds.
Who Are Mehra and Prescott?
Rajnish Mehra and Edward C. Prescott are economics professors at the W.P. Carey School of Business at Arizona State University. Notably, Professor Prescott won the Nobel Memorial Prize in Economics in 2004 for his work on business cycles and demonstrating that "society could gain from prior commitment to economic policy," according to a statement by the prize organization.