Equity premium puzzle Definition
The equity premium puzzle refers to the phenomenon that observed returns on stocks over the past century are higher, by approximately 6%, than returns on government bonds. Economists expect arbitrage opportunities would reduce the difference in returns on these two investment opportunities to reflect the risk premium investors demand to invest in relatively more risky stocks. The puzzle arises as the observed difference in returns implies an implausibly high level of risk aversion. To quantify the level of risk aversion implied, investors would have to be indifferent betwen a bet with a 50% chance of $50,000 or $100,000 and a certain payoff of $51,209.
A large number of explanations for the puzzle have been proposed. These include a contention that the puzzle is a statistical illusion, others tweak the preferences of investors to account for the liquidity of stocks and some suggest market imperfections. Kocherlakota (1996) presents a detailed analysis of these explanations and strongly concludes that the puzzle is real and that the fundamental puzzle, the excessively high implied level of risk aversion, remains unexplained.
An alternative explanation for the puzzle has been proposed by Benartzi and Thaler (1995). Applying prospect theory they contend that myopic loss aversion provides a plausable solution to the puzzle. They assert that investors evaluate their portfolio in a relatively short sighted way and that, as loss aversion implies, they are highly sensitive to losses over this time period. The evaluation time period implied in their model by a 6% equity premium and a 2x loss aversion multiplier (a general finding of loss aversion research) is approximately one year. This explanation does seem consistent with the data and has not, to date, been rebutted.