What is the Equity Premium Puzzle?

The Equity Premium Puzzle is a term used for the unexplained disparity between returns on stocks, and the average returns on bonds or treasury bills (T-bills).

It was first identified in 1985 when Rajnish Mehra and Edward C. Prescott published a study called The Equity Premium: A Puzzle, based on a paper published in 1982 titled A Test of the Intertemporal Asset Pricing Model. In this study, the two economists identified that stocks tend to earn a significantly better return than government bonds, even though government bonds are objectively safer.

According to their findings, in the 90 years from 1889 to 1978, the average stock market return was 6.98%, whereas the return on Treasury Bills (a form of bond in the US) was only 0.8%. Based on the Consumption Capital Asset Pricing Model (CCAPM) – a financial model designed to calculate expected returns – the expected returns for the stock market should sit around 0.35% per year and not the 5-8% average it’s currently at.

This gap between the return on stocks and the return on bonds is known as the equity risk premium. The equity risk premium is also a calculation of the extra return that investors should be owed for taking on greater risk, which can then be used to calculate certain things such as dividends and expected returns.

While some economists explain the unexplained difference to be down to the extra money investors receive for taking on risk, most economists agree that the difference is still too high to make any sense, as stocks are still much riskier than bonds.

Stocks vs bonds

It’s important to understand in this puzzle the difference between stocks and bonds. A stock represents ownership of a company, which for huge companies often amounts to a tiny percentage. They can be public or private too, depending on the company.

Bonds are a little different, when you buy a bond, you take the role of a creditor. A bond in its basic form works by a government or company asking for money from you, which they promise to return after a fixed amount of time, with a return. This return is known as the yield. For example, two-year UK government bonds currently have a yield of 5.093%.

Stocks carry higher risk, as the value of the company or fund that you have put your money into can easily lose value. Whereas with bonds, the only risk is that the company or government could default, which is less likely to happen. Bondholders also have guaranteed priority over shareholders, so in the instance that money might be tight, your return is promised to you regardless, whereas dividends might not come if the company defaults or falls into financial trouble.

In short, bonds are the closest thing to a guarantee. You invest your money in a government or established company for a fixed term and are promised a return at the end of the period. Stocks make no such promise, and can often wildly fluctuate in value as they are much more exposed to the market.

Therefore, bonds represent a much clearer return, as you are promised to see that return, and your human impulse won’t affect the outcome. But as Mehra and Prescott identified in their study, this isn’t the case, and stocks still perform better on average.

What causes the Equity Premium Puzzle?

The answer to this question is still unknown, and research continues. But economists have many theories about what might be causing it, and as the economy develops, new theories often arise about what might cause it.

There is also a chance it could reveal our lack of understanding about what money and the market are, and expose a gap in our understanding of human behaviour. Here are some of the main suggestions about what might be causing the equity risk premium to be so large.

Unconventional Investing

Investors will not always follow conventional models and will exhibit habits that don’t always follow the data, such as following the crowd or investing in what is fashionable. Standard economic models state that humans are naturally risk averse, and will always employ the best strategy to reduce risk, but the data suggests that people could be following habits and other irrational behaviour, rather than what the empirical data shows them.

Risk aversion

As the market enters more volatile periods, investors will likely change their behaviour and investors may demand higher returns to compensate for the increased risk they’re taking on, which is at the discretion of the company. Bonds have no such problem, as the bond duration is fixed regardless of the market. Interest rates may rise, which can affect the bonds, but there is no fluctuation in the money that will be received back. But this could be an explanation for the disparity in returns.

Cognitive Bias

Overconfidence and investor bias have also been presented as potential explanations. Behavioural finance suggests that individuals’ decision-making processes are a direct result of cognitive bias and that this results in assets being overpriced and inflating hugely in value. This could be an explanation for a large portion of the stock market’s value, and therefore an answer to the Equity Premium Puzzle.

The Prospect Theory

Also known as the ‘loss-aversion’ theory, the Prospect theory states that individuals will often make decisions based on perceived gains instead of losses. In theory, if someone is presented with two stocks, they will always pick the choice which offers greater gains, rather than the one with less risk.

In the context of the Equity Premium Puzzle, this means that investors may demand a higher risk premium due to the significant fear of losses, which would explain the higher returns compared to bonds.

Will the puzzle solve itself?

Several economists have also suggested that due to it being an anomaly, the Equity Premium Puzzle is down to unique events that have happened in the past century, such as the gigantic spike in population and a general increase in economic activity.

A growing population creates a situation where more businesses have consistently more customers, which leads to growth and higher stock market returns. This can be seen in countries with declining populations, such as Japan, which have experienced lower stock market performances. There is a chance that when the population peaks at some point in the 21st century, the equity risk premium may begin to fall and more closely align with the return on bonds.

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