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The equity premium puzzle explores why stocks have historically outperformed bonds and Treasury bills, challenging traditional utility theory. Originally identified by Rajnish Mehra and Edward Prescott in 1985, this phenomenon raises questions regarding loss aversion and investor behavior. Data analyzes a real premium of 4.3% in the US (1921-1996) against a global median of 0.8%. Achieving a 5% confidence level in the equity premium requires extensive data—44 years for a 6% premium, or 178 years for a 3% premium. This discussion bridges finance with behavioral economics, shedding light on market expectations and investor psychology.
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Behavioral Finance Economics 437
Equity Premium Puzzle • Why have stocks earned so much more than bonds? (…than treasury bills?) • Not consistent with any reasonable utility function • Loss aversion is usual behavioral explanation • Originally noted by RajnishMehra and Edward Prescott in 1985
Philippe Jorion & William Goetzmann, 1999 • How sure are we that 6 percent premium implies a positive equity premium? • 5 % confidence interval would require 44 years of data • If 3 percent, then 178 years of data to get to the 5 % confidence level • Equity Premium = Rs -RTB • = [CRs + IRs] - [Inflation + Real Rate] • = [CRs - Inflation] + [IRs - Real Rate]. • = approx [CRs – Inflation]
The Data • 39 Markets • 1921 – 1996 • US has 4.3 % real appreciation over the period • Median for all countries is 0.8 % • Globally diversified real return is 4.0 % (3.26 % if everything invested outside of the US is lost)
