Equity Premium Puzzle - EPP

Categories: Econ, Metrics, Investing

Economists and financial academics are stumped by the equity premium puzzle (EPP), which was found in a 1985 paper.

Using standard economic models and financial theory, the long-run expected values of stocks and bonds should equal each other. Basically, economists expect supply and demand to make long-run profits of stocks and bonds even out, as they often do in consumer markets.

For instance, say you invested $500 in a stock and expected $700 in return. That’s a $200 profit for you. If that’s better returns than other places, it should lead to increased demand, which should make the price of the stock go up. For instance, more and more people buying that stock might lead to a price change in the stock from $500 to $600. Yet the returns are still $700, which means returns are now only $100 instead of $200 for those buying in later at the higher price. Since the returns from this stock are now shrinking since it’s so popular, economists would expect you and everyone else to find something with better returns.

This theory in the marketplace would mean the expected returns from stocks and bonds should equal out over time. But...they don’t. The last 100 years of data says that, on average, investors are getting 3-7% more in returns from stocks than from bonds in the long run. Which means that, even though there’s money to be made, people aren’t investing in stocks like they are in bonds, suggesting that people in the aggregate are irrationally risk averse.

Many economists have tried to explain this phenomena, but to no avail. The takeaway? Invest in stocks before everyone else does and raises the prices, lowering the returns you could get...you’ll get much better rewards than on government bonds.

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