Summary: The equity premium puzzle is a term coined in 1985 by economists Rajnish Mehra and Edward C. Prescott. It is based on the observation that in order to reconcile the much higher return on equity stock compared to government bonds in the United States, individuals must have implausibly high risk aversion according to standard economics models. Similar situations prevail in many other industrialized countries. The puzzle has led to an extensive research effort in both macroeconomics and finance. So far a range of useful theoretical tools and several plausible explanations have been presented, but a solution generally accepted by the economics profession remains elusive.

In addition to explanations of the puzzle, some deny that there is an equity premium at all; notably, following the stock market crashes of the late 2000s recession, there has been no global equity premium over the 30-year period 1979–2009, as observed by Bloomberg.

In the United States, the observed “equity premium”—the risk premium (in fact the historical outperformance) on equity in stocks vs. government bonds—over the past century was approximately 7% per annum. However, over any one decade, the outperformance had great variability—from over 19% in the 1950s to 0.3% in the 1970s. It is this gap that is much larger than would be predicted on the basis of standard models of financial markets and assumptions about risk attitudes. To quantify the level of risk aversion implied if these figures represented the expected outperformance of equities over bonds, investors would have to be indifferent between a bet equally likely to pay $50,000 or $100,000 (an expected value of $75,000) and a certain payoff of $51,209 (Mankiw and Zeldes, 1991).

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Myopic Loss Aversion and the Equity Premium Puzzle

The equity premium puzzle refers to the empirical fact that stocks have outperformed bonds over the last century by a surprisingly large margin. The authors offer a new explanation based on two behavioral concepts. First, investors are assumed to be ‘loss averse,’ meaning that they are distinctly more sensitive to losses than to gains. Second, even long-term investors are assumed to evaluate their portfolios frequently. The authors dub this combination ‘myopic loss aversion.’ Using simulations, they find that the size of the equity premium is consistent with the previously estimated parameters of prospect theory if investors evaluate their portfolios annually. Copyright 1995, the President and Fellows of Harvard College and the Massachusetts Institute of Technology.

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The Equity Premium: It’s Still a Puzzle

OVER THE LAST one hundred years, the average real return to stocks in the United States has been about six percent per year higher than that on Treasury bills. At the same time, the average real return on Treasury bills has been about one percent per year. In this paper, I discuss and assess various theoretical attempts to explain these two different empirical phenomena: the large “equity premium” and the low “risk free rate.” I show that while there are several plausible explanations for the low level of Treasury returns, the large equity premium is still largely a mystery to economists.

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