Definition
The Equity Premium Puzzle (EPP) refers to the inconsistency between observed returns on stocks and bonds and the theoretical predictions of economic models. Traditionally, stocks have demonstrated significantly higher returns than bonds, which is puzzling because the risk aversion levels assumed in standard economic models cannot explain the magnitude of this observed difference. Therefore, the EPP challenges economists to resolve this discrepancy between expected and actual market behaviors.
Phonetic
The phonetics for “Equity Premium Puzzle (EPP)” are:Equity: /ˈɛkwɪti/Premium: /ˈpriːmiəm/Puzzle: /ˈpʌzəl/EPP: /ˈi: p: pi:/
Key Takeaways
- The High Equity Premium: The Equity Premium Puzzle (EPP) revolves around the observation that historical rates of return on equities have been significantly higher than those on risk-free bonds. In other words, the equity premium – the difference between the average return on a market portfolio of equities and the risk-free rate – is too high to be explained within the conventional asset-pricing theory.
- Risk-Aversion Contradiction: The EPP represents a disagreement with people’s levels of risk aversion and their financial behaviors. According to observed equity premiums, people should be far more risk-averse than they appear to be in daily life. This contradiction between theory and observed behavior is a fundamental aspect of the Equity Premium Puzzle.
- Need for New Explanations or Models: Since traditional models are unable to adequately explain the EPP, it suggests that some important elements are missing from these models. Therefore, the EPP has led to several new efforts to explain it, including behavioral finance and the argument that financial markets may not be as efficient as classical theory assumes.
Importance
The Equity Premium Puzzle (EPP) is important in the field of business and finance as it refers to the phenomenon where real returns on common stocks significantly outperform real returns on risk-free assets such as government bonds, contradicting traditional economic theory. The substantial difference in returns, also known as the equity premium, is puzzling because it seems irrational for risk-averse investors to demand such a high return for bearing apparently low level of risk. Understanding and resolving this puzzle has profound implications for financial market behavior, asset pricing, risk management, and economic policy-making. It challenges traditional financial models and theories, prompting the development of more sophisticated approaches to better explain and predict investor behavior and market dynamics.
Explanation
The Equity Premium Puzzle (EPP) is a well-established issue in finance and economics that is used to study the inherent discrepancy between the theoretical predictions and empirical observations of the risk premium on investing in stocks. In essence, it explores why people require a significantly higher return to invest in stocks compared to investment in risk-free bonds. The purpose of this concept is to probe the reason why the real-world differential in returns – the ‘equity premium’ – is much larger than what financial theories typically predict. The EPP serves as a litmus test for our understanding of financial market behavior and has been used to refine our theories of risk and return.The EPP has been a catalyst for financial and economic models to incorporate more realistic assumptions about human behavior, leading to progression in the field of behavioral finance. The puzzle’s existence suggests that either our measurements of risk aversion are flawed, or that economic models need to reflect more complexity. In practical terms, the EPP is used to explain and predict investment behavior, guide policy-making, and better understand financial markets. It plays an important role in stock valuation, financial planning, portfolio management, and risk management. By seeking to resolve the EPP, researchers and practitioners aim to enhance the precision of investment decisions, create more accurate financial models, and better understand the relationship between risk and return.
Examples
1. Stock Market Performance: The most common real-world example of the Equity Premium Puzzle (EPP) comes from the performance of the stock market itself. Economists Rajnish Mehra and Edward Prescott first identified the puzzle when they noticed that over a span of several decades, the average real return on stocks was significantly higher than that on government bonds, despite their relative risks.2. Real Estate Market: Consider the real estate market where investors demand higher returns on equity investments in real estate properties than the return they could have gotten investing the same money in risk-free government bonds. The higher returns on equity investments attract more investors despite the associated risk, which is much higher than that of the risk-free bonds. This is a typical example of the EPP where the returns on risky investments are significantly higher than the returns of risk-free investments.3. Tech Startups: Tech startups often face the volume of the equity premium puzzle. Venture capitalists and angel investors often demand significant equity in the company in exchange for their investments. Despite the associated risks, including potential failure of the startup, they expect a high return on their equity stake. This compares to what they could get from risk-free investments such as government notes. The high-risk premium demanded by these investors is a real-world example of the EPP, where the expected returns are significantly higher than that of risk-free investments.
Frequently Asked Questions(FAQ)
What is the Equity Premium Puzzle (EPP)?
The Equity Premium Puzzle (EPP) is a financial concept that describes the abnormally higher rates of return on equity compared to risk-free assets like bonds, which cannot be explained by conventional measures of risk.
Who first identified the EPP?
The Equity Premium Puzzle was first identified by economists Rajnish Mehra and Edward C. Prescott in a study published in 1985.
What contributes to the Equity Premium Puzzle?
The puzzle arises from the discrepancy between the theoretically predicted returns on risk-free assets and the empirical fact that the average returns on equity are significantly higher.
How is EPP calculated?
The equity premium, which is the basis of the EPP, is calculated by subtracting the risk-free rate, usually determined by the interest rate of a risk-free bond, from the expected or actual return on a stock or portfolio of stocks.
Why is the EPP considered a puzzle?
It’s considered a puzzle because according to financial theory, people should strive for a balance between risk and reward. So if investing in stocks is inherently riskier, the returns they offer should compensate for that risk, but not exceed it to the extent that they have historically.
How does the EPP affect investors?
EPP suggests that over the long term, equity investments like stocks have potentially higher returns than safer assets like bonds and can thus influence the investment decisions of individuals and institutions, who may favor equities in pursuit of those higher returns.
Are there any solutions to the EPP?
Numerous financial theorists have proposed solutions to resolve the discrepancy, but to date, there is no universally accepted explanation for the EPP. The potential solutions revolve around easing the standard assumptions of financial theory, including modifying risk aversion levels or varying the probability assumptions for the returns on risky and risk-free assets.
How does the Equity Premium Puzzle affect my understanding of risk and investment?
The EPP can deepen your understanding of risk levels, helping you realize that commonly accepted risk measurements might fall short in explaining actual market behavior. It can encourage you to explore additional methods and strategies to calculate returns on your investment beyond the traditional methods.
Related Finance Terms
- Risk Aversion
- Stock Market Returns
- Mehra-Prescott Puzzle
- Discounted Cash Flow
- CAPM (Capital Asset Pricing Model)
