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The Equity Premium Puzzle

The Equity Premium Puzzle. Economics 437. What is the “equity premium”. R M - R f. Market return minus the risk free rate. Mehra & Prescott……..1985. Using data over 1889-1978 period Found 6 % equity risk premium Too high to be consistent with reasonable levels of “risk aversion”

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The Equity Premium Puzzle

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  1. The Equity Premium Puzzle Economics 437

  2. What is the “equity premium” RM - Rf Market return minus the risk free rate

  3. Mehra & Prescott……..1985 • Using data over 1889-1978 period • Found 6 % equity risk premium • Too high to be consistent with reasonable levels of “risk aversion” • Popular version of this: Jeremy Siegel’s “Stocks for the Long Run”

  4. “Survival” by Brown Goetzmann and Ross 1995 (Journal of Finance) • Possible price paths disappear • Price paths conditional on survival have • Higher mean returns • Serial correlation: Specifically, mean reversion • Applications: • Equity premium puzzle • Earnings momentum

  5. Philippe Jorion & William Goetzmann, “Global Stock Markets in the Twentieth Century” • Mehra & Prescott took people off in the wrong direction: • Trying to find new utililty functions that fit very high equity risk premium estimates • Infrequent crashes (one every 250 years) [Rietz, 1988]

  6. Jorion Goetzmann • Analyze 38 markets • US real rate of appreciation: 4.3% • Median real rate of appreciation: 0.8% • 11occurences of “permanent breaks” • Reduced returns from global portfolio returns from 4.33 (for surviviors) to 4.04 (survivors plus non survivors) • Implications • US is a “survivor” in the data • Rietz explanation (crashes) doesn’t fit

  7. End

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