Equity Over Bond Returns Premium Puzzle
An Equity Over Bond Returns Premium Puzzle is a puzzle of the persistence of the equity over bond returns premium (equity returns minus bond return).
References
2014
- (Wikipedia, 2014) ⇒ http://en.wikipedia.org/wiki/equity_premium_puzzle Retrieved:2014-8-5.
- The equity premium puzzle refers to the phenomenon that observed returns on stocks over the past century are a few percent higher than returns on government bonds. It is a term coined by Rajnish Mehra and Edward C. Prescott in 1985. [1] Economists expect arbitrage opportunities would reduce the difference in returns on these two investment opportunities to reflect the risk premium investors demand to invest in relatively more risky stocks. The intuitive notion that stocks are much riskier than bonds is not a sufficient explanation as the magnitude of the disparity between the two returns, the equity risk premium (ERP), is so great that it implies an implausibly high level of investor risk aversion that is fundamentally incompatible with other branches of economics, particularly macroeconomics and financial economics. The process of calculating the equity risk premium, and selection of the data used, is highly subjective to the study in question, but is generally accepted to be in the range of 3–7% in the long-run. Dimson et al. calculated a premium of "around 3–3.5% on a geometric mean basis" for global equity markets during 1900–2005 (2006). However, over any one decade, the premium shows great variability — from over 19% in the 1950s to 0.3% in the 1970s. To quantify the level of risk aversion implied if these figures represented the expected outperformance of equities over bonds, investors would prefer a certain payoff of $51,300 to a 50/50 bet paying either $50,000 or $100,000.
The puzzle has led to an extensive research effort in both macroeconomics and finance. So far a range of useful theoretical tools and numerically plausible explanations have been presented, but no one solution is generally accepted by economists.
- The equity premium puzzle refers to the phenomenon that observed returns on stocks over the past century are a few percent higher than returns on government bonds. It is a term coined by Rajnish Mehra and Edward C. Prescott in 1985. [1] Economists expect arbitrage opportunities would reduce the difference in returns on these two investment opportunities to reflect the risk premium investors demand to invest in relatively more risky stocks. The intuitive notion that stocks are much riskier than bonds is not a sufficient explanation as the magnitude of the disparity between the two returns, the equity risk premium (ERP), is so great that it implies an implausibly high level of investor risk aversion that is fundamentally incompatible with other branches of economics, particularly macroeconomics and financial economics. The process of calculating the equity risk premium, and selection of the data used, is highly subjective to the study in question, but is generally accepted to be in the range of 3–7% in the long-run. Dimson et al. calculated a premium of "around 3–3.5% on a geometric mean basis" for global equity markets during 1900–2005 (2006). However, over any one decade, the premium shows great variability — from over 19% in the 1950s to 0.3% in the 1970s. To quantify the level of risk aversion implied if these figures represented the expected outperformance of equities over bonds, investors would prefer a certain payoff of $51,300 to a 50/50 bet paying either $50,000 or $100,000.
- ↑ Handbook of the Equity Risk Premium, edited by Rajnish Mehra
2013
- http://www.investopedia.com/terms/e/epp.asp
- QUOTE: An phenomenon that describes the anomalously higher historical real returns of stocks over government bonds. The equity premium, which is defined as equity returns less bond returns, has been about 6% on average for the past century. It is supposed to reflect the relative risk of stocks compared to "risk-free" government bonds, but the puzzle arises because this unexpectedly large percentage implies a suspiciously high level of risk aversion among investors.
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The equity premium puzzle is a mystery to financial academics. According to some academics, the difference is too large to reflect a "proper" level of compensation that would occur as a result of investor risk aversion; therefore, the premium should actually be much lower than the historic average of 6%.
More recent extensions to the puzzle attempt to offer a different rationale for explaining the EPP, such as investor prospects and macroeconomic influences. No matter the explanation, the fact remains that investors are being rewarded very well for holding equity compared to government bonds.
- QUOTE: An phenomenon that describes the anomalously higher historical real returns of stocks over government bonds. The equity premium, which is defined as equity returns less bond returns, has been about 6% on average for the past century. It is supposed to reflect the relative risk of stocks compared to "risk-free" government bonds, but the puzzle arises because this unexpectedly large percentage implies a suspiciously high level of risk aversion among investors.