The Equity Premium Puzzle

The equity premium is how much a diversified portfolio of stock is expected to earn beyond the returns expected from a risk-free asset. This chapter presents whether equity risk premium found in Mehra and Prescott's data, which was 6.18% in real terms, is too high, too low, or just about right. This is a puzzle. Therefore, the simple answer to the puzzle might be that individuals are very risk averse and prefer present to future consumption by a wide margin. They therefore, see no reason to take on the risk of stocks and are satisfied with the much lower returns from relatively safe securities. The equity premium puzzle that Mehra and Prescott brought to the attention of the academic community spawned a very large literature designed either to debunk the puzzle or to explain it. While this discussion is not over, two important strands of research seem promising. The first is behavioral and the second is more global in character. While, loss aversion can explain the equity premium puzzle, it leaves finance theory in a precarious situation, since loss-averse utility functions do not fit neatly into much of existing finance theory. However, yet, the equity premium puzzle remains a puzzle.