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"In the US, equities have outperformed bonds by around 7% p.a. for most of the 20th century. Economists have long been puzzled by the magnitude of this outperformance. For sure annual stock returns are more volatile than annual bond returns. But most models used by economists show an equity risk premium of 1 - 2 % maximum. Why should stocks require such a large compensation for their risk.
Benartzi and Thaler (1995) propose an explanation based on prospect theory. What if investors aren't risk-averse over variable returns, but rather they care about the chance of a loss"
"...the equity premium , the extra return that people require to be compensated for the risk of investing in the stock market..."
Possible explanations of the equity premium puzzle:
The puzzle is an illusion: the empirical data are wrong
High risk aversion
Nonstandard utility functions
Autocorrelation in returns
Time varying expected returns
Heterogeneous investors
Or, more likely, a mixture of the above.
Book
Top 10 Papers
MEHRA, R. and N.A.T.I.O.N.A.L. BUREAU, 2003. The Equity Premium: Why is it a Puzzle? . [Cited by 2418 ] (446.17/year)
CONSTANTINIDES, G.M., 1990. Habit Formation: A Resolution of the Equity Premium Puzzle . Journal of Political Economy. [Cited by 961 ] (52.17/year)
BENARTZI, S. and R.H. THALER, 1993. Myopic Loss Aversion and the Equity Premium Puzzle . NBER Working Paper. [Cited by 879 ] (57.01/year)
WEIL, P. and N.A.T.I.O.N.A.L. BUREAU, 1989. The Equity Premium Puzzle and the Riskfree Rate Puzzle . [Cited by 646 ] (33.27/year)
… FOR EMPIRICAL MACROECONOMICS, FEDERAL RESERVE BANK …, 1996. The Equity Premium: It's Still a Puzzle . JOURNAL OF ECONOMIC LITERATURE. [Cited by 643 ] (51.77/year)
MOSKOWITZ, T.J. and A. VISSING-JORGENSEN, The Private Equity Premium Puzzle . papers.ssrn.com. [Cited by 306 ] (?/year)
FAMA, E.F. and K.R. FRENCH, 2002. The Equity Premium . The Journal of Finance. [Cited by 346 ] (53.90/year)
MANKIW, N.G., 1987. The Equity Premium and the Concentration of Aggregate Shocks . NBER Working Paper. [Cited by 188 ] (8.78/year)
SIEGEL, J.J., 1999. The Shrinking Equity Premium (Digest Summary) . Journal of Portfolio Management. [Cited by 120 ] (12.74/year)
CONSTANTINIDES, G.M., J.B. DONALDSON and R. MEHRA, 2002. Junior Can't Borrow: A New Perspective on the Equity Premium Puzzle* . Quarterly Journal of Economics. [Cited by 227 ] (35.36/year)
Bibliography
… FOR EMPIRICAL MACROECONOMICS, FEDERAL RESERVE BANK …, 1996. The Equity Premium: It's Still a Puzzle . JOURNAL OF ECONOMIC LITERATURE. [Cited by 643 ] (51.77/year)
AASE, K.K., 1993. A Jump/Diffusion Consumption-Based Capital Asset Pricing Model and the Equity Premium Puzzle . Mathematical Finance. [Cited by 22 ] (1.43/year)
ABEL, A.B., 1991. The equity premium puzzle . Business Review. [Cited by 39 ] (2.24/year)
ABEL, A.B., 1992. … for Expected Rates of Return Under Markov Regime Switching: Implications for the Equity Premium … . NBER Working Paper. [Cited by 42 ] (2.56/year)
ABEL, A.B. and N.A.T.I.O.N.A.L. BUREAU, 1991. Asset Prices under Habit Formation and Catching up with the Joneses . [Cited by 884 ] (50.75/year)
ABEL, A.B. and R.O.D.N.E.Y. L., 1989. Asset Prices Under Heterogenous Beliefs: Implications for the Equity Premium . ideas.repec.org. [Cited by 26 ] (1.34/year)
AIT-SAHALIA, Y., J.A. PARKER and M. YOGO, 2004. Luxury Goods and the Equity Premium . The Journal of Finance. [Cited by 97 ] (21.95/year)
AIYAGARI, S.R., M. GERTLER and N.A.T.I.O.N.A.L. BUREAU, 1990. Asset Returns with Transactions Cost and Uninsured Risk: A Stage III Exercise . [Cited by 183 ] (9.94/year)
BANSAL, R. and W.J.C. II, 1996. A Monetary Explanation of the Equity Premium, Term Premium, and Risk-Free Rate Puzzles . Journal of Political Economy. [Cited by 89 ] (7.17/year)
BARBERIS, N., M. HUANG and R.H. THALER, 2003. Individual Preferences, Monetary Gambles and the Equity Premium . NBER Working Paper. [Cited by 33 ] (6.09/year)
BARRO, R.J., 2005. Rare Events and the Equity Premium . NBER Working Paper. [Cited by 27 ] (7.90/year)
BEN-HAIM, Y., 2006. Info-gap Decision Theory: Decisions Under Severe Uncertainty . books.google.com. [Cited by 244 ] (100.85/year)
BENARTZI, S. and R.H. THALER, 1993. Myopic Loss Aversion and the Equity Premium Puzzle . NBER Working Paper. [Cited by 879 ] (57.01/year)
BENNINGA, S. and A. PROTOPAPADAKIS, 1990. Leverage, time preference, and the ‘equity premium puzzle . Journal of Monetary Economics. [Cited by 41 ] (2.23/year)
BLANCHARD, O., 1993. The Vanishing Equity Premium. Finance and the International Economy 7: The AMEX Bank …. [Cited by 45 ] (2.92/year)
BLANCHARD, O.J., 1993. Movements in the Equity Premium. Brookings Papers on Economic Activity. [Cited by 164 ] (10.64/year)
BOLDRIN, M., et al. , 2000. Habit Persistence, Asset Returns, and the Business Cycle . [Cited by 302 ] (35.87/year)
BONOMO, M., R. GARCIA and R. GARCIA, 1993. Disappointment aversion as a solution to the equity premium and the risk-free rate puzzles . [Cited by 26 ] (1.69/year)
BRENNAN, M.J., 1997. The Role of Learning in Dynamic Portfolio Decisions . European Finance Review. [Cited by 175 ] (15.32/year)
BRENNAN, M.J. and Y. XIA, 2001. Stock price volatility and equity premium . Journal of Monetary Economics. [Cited by 128 ] (17.25/year)
BRENNAN, M.J. and Y. XIA, 2001. Stock Return Volatility and Equity Premium. Journal of Monetary Economics. [Cited by 22 ] (2.97/year)
CAMPBELL, J.Y. and S.B. THOMPSON, Predicting the Equity Premium Out of Sample: Can Anything Beat the Historical Average? . papers.ssrn.com. [Cited by 81 ] (?/year)
CECCHETTI, S.G., 1991. The equity premium and the risk free rates. [Cited by 16 ] (0.92/year)
CECCHETTI, S.G., P.O.K.S. LAM and N.C. MARK, 1991. The Equity Premium and the Risk Free Rate: Matching the Moments . NBER Working Paper. [Cited by 138 ] (7.92/year)
CECCHETTI, S.G., P.O.K.S. LAM and N.C. MARK, 1998. Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good To Be True? . NBER Working Paper. [Cited by 118 ] (11.32/year)
CHAPMAN, D.A., 2002. Does Intrinsic Habit Formation Actually Resolve the Equity Premium Puzzle? . Review of Economic Dynamics. [Cited by 16 ] (2.49/year)
CHEN, L., P. COLLIN-DUFRESNE and R.S. GOLDSTEIN, On the Relation between the Credit Spread Puzzle and the Equity Premium Puzzle . papers.ssrn.com. [Cited by 37 ] (?/year)
COGLEY, T., 2002. Idiosyncratic risk and the equity premium: evidence from the consumer expenditure survey . Journal of Monetary Economics. [Cited by 74 ] (11.53/year)
CONSTANTINIDES, G.M., 1990. Habit Formation: A Resolution of the Equity Premium Puzzle . Journal of Political Economy. [Cited by 961 ] (52.17/year)
CONSTANTINIDES, G.M. and D. DUFFIE, 1996. Asset Pricing with Heterogeneous Consumers . Journal of Political Economy. [Cited by 473 ] (38.09/year)
CONSTANTINIDES, G.M., J.B. DONALDSON and R. MEHRA, 2002. Junior Can't Borrow: A New Perspective on the Equity Premium Puzzle* . Quarterly Journal of Economics. [Cited by 227 ] (35.36/year)
DAMODARAN, A., 2001. The dark side of valuation . [Cited by 122 ] (16.44/year)
DANIEL, K. and D. MARSHALL, 2005. EQUITY-PREMIUM AND RISK-FREE-RATE PUZZLES AT LONG HORIZONS . Macroeconomic Dynamics. [Cited by 54 ] (15.79/year)
DANTHINE, J.P., J.B. DONALDSON and R. MEHRA, 1992. The Equity Premium and the Allocation of Income Risk . Journal of Economic Dynamics and Control. [Cited by 35 ] (2.13/year)
DEANGELO, H., L. DEANGELO and D.J. SKINNER, 1992. Dividends and Losses . JOURNAL OF FINANCE-NEW YORK-. [Cited by 136 ] (8.28/year)
DIMSON, E., P. MARSH and M. STAUNTON, Global Evidence on the Equity Risk Premium . papers.ssrn.com. [Cited by 59 ] (?/year)
DIMSON, E., P. MARSH and M. STAUNTON, THE WORLDWIDE EQUITY PREMIUM: A SMALLER PUZZLE . papers.ssrn.com. [Cited by 32 ] (?/year)
EPSTEIN, L.G., et al. , 1989. 'First Order'Risk Aversion and the Equity Premium Puzzle. Dept. of Economics and Institute for Policy Analysis, University …. [Cited by 144 ] (7.42/year)
FAMA, E.F. and K.R. FRENCH, 2002. The Equity Premium . The Journal of Finance. [Cited by 346 ] (53.90/year)
FAMA, E.F. and R. KENNETH, 2002. French, 2002, The equity premium. Journal of Finance. [Cited by 112 ] (17.45/year)
FISHER, S.J., 1994. Asset Trading, Transaction Costs and the Equity Premium . JOURNAL OF APPLIED ECONOMETRICS. [Cited by 19 ] (1.32/year)
GABAIX, X. and D. LAIBSON, The 6D Bias and the Equity Premium Puzzle . papers.ssrn.com. [Cited by 105 ] (?/year)
GALI, J., 1994. Keeping Up with the Joneses: Consumption Externalities, Portfolio Choice, and Asset Prices. . Journal of Money, Credit & Banking. [Cited by 233 ] (16.16/year)
GOYAL, A. and I. WELCH, 2007. A Comprehensive Look at the Empirical Performance of Equity Premium Prediction - ► afajof.org [PDF] . Review of Financial Studies. [Cited by 150 ] (105.67/year)
GOYAL, A. and I. WELCH, 1999. Predicting the Equity Premium. manuscript, Yale University. [Cited by 26 ] (2.76/year)
GOYAL, A. and I. WELCH, 2003. The Myth of Predictability: Does the Dividend Yield Forecast the Equity Premium?. Management Science. [Cited by 20 ] (3.69/year)
GOYAL, A. and I.V.O. WELCH, Predicting the Equity Premium with Dividend Ratios . papers.ssrn.com. [Cited by 198 ] (?/year)
GRAHAM, J.R. and C.R. HARVEY, 2005. The long-run equity risk premium . Finance Research Letters. [Cited by 17 ] (4.97/year)
GRANT, S. and J. QUIGGIN, 2003. Public Investment and the Risk Premium for Equity . Economica. [Cited by 20 ] (3.69/year)
HEATON, J. and D. LUCAS, 1993. Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing . papers.ssrn.com. [Cited by 541 ] (35.09/year)
JAGANNATHAN, R., E.R. MCGRATTAN and A. SCHERBINA, 2000. The Declining US Equity Premium . FEDERAL RESERVE BANK OF MINNEAPOLIS QUARTERLY REVIEW. [Cited by 156 ] (18.53/year)
JAIN, P.K., 2005. Financial Market Design and the Equity Premium: Electronic versus Floor Trading . The Journal of Finance. [Cited by 31 ] (9.07/year)
JERMANN, U.J., 1998. Asset pricing in production economies . Journal of Monetary Economics. [Cited by 241 ] (23.13/year)
KAPUR, S., et al. , 1999. A Portfolio Approach to Investment and Annuitization during Retirement. DISCUSSION PAPER IN ECONOMICS-BIRKBECK COLLEGE. [Cited by 35 ] (3.72/year)
KEIM, D.B., 1982. Size Related Anomalies and Stock Return Seasonality: Further Empirical Evidence . ideas.repec.org. [Cited by 602 ] (22.79/year)
KIM, C.J., J.C. MORLEY and C.R. NELSON, 2004. Is There a Positive Relationship between Stock Market Volatility and the Equity Premium? . Journal of Money, Credit & Banking. [Cited by 21 ] (4.75/year)
KURZ, M. and A. BELTRATTI, The Equity Premium is No Puzzle . papers.ssrn.com. [Cited by 31 ] (?/year)
KURZ, M. and M. MOTOLESE, 2001. Endogenous uncertainty and market volatility . Economic Theory. [Cited by 83 ] (11.19/year)
LABADIE, P., I.N.S.T.I.T.U.T.E. FOR and &.h.e.l.l.i.p.;. , 1989. Stochastic Inflation and the Equity Premium . [Cited by 60 ] (3.09/year)
LETTAU, M., 2002. … Risk and Volatility Bounds, or Can Models with Idiosyncratic Risk Solve the Equity Premium Puzzle? . Review of Economics and Statistics. [Cited by 21 ] (3.27/year)
LETTAU, M., S. LUDVIGSON and J.A. WACHTER, 2004. The Declining Equity Premium: What Role Does Macroeconomic Risk Play? . NBER Working Paper. [Cited by 81 ] (18.33/year)
LI, H. and Y. XU, 2002. Survival Bias and the Equity Premium Puzzle . The Journal of Finance. [Cited by 32 ] (4.98/year)
LONGSTAFF, F.A. and M. PIAZZESI, 2004. Corporate earnings and the equity premium . Journal of Financial Economics. [Cited by 29 ] (6.56/year)
LUCAS, D.J., 1994. … Pricing with Undiversifiable Income Risk and Short Sales Constraints: Deepening the Equity Premium … . Journal of Monetary Economics. [Cited by 160 ] (11.10/year)
LYNCH, A.W., 1996. Decision Frequency and Synchronization Across Agents: Implications for Aggregate Consumption and … . JOURNAL OF FINANCE-NEW YORK-. [Cited by 50 ] (4.03/year)
MANKIW, N.G., 1987. The Equity Premium and the Concentration of Aggregate Shocks . NBER Working Paper. [Cited by 188 ] (8.78/year)
MANKIW, N.G. and S.P. ZELDES, 1991. The Consumption of Stockholders and Nonstockholders . Journal of Financial Economics. [Cited by 526 ] (30.20/year)
MCGRATTAN, E.R. and E.C. PRESCOTT, 2003. Average Debt and Equity Returns: Puzzling? . American Economic Review. [Cited by 78 ] (14.39/year)
MEHRA, R. and E. PRESCOTT, 2002. The Equity Premium Puzzle in Retrospect. Handbook of Economics of Finance (Amsterdam: North Holland). [Cited by 20 ] (3.12/year)
MEHRA, R. and E. PRESCOTT, 1985. HThe Equity Premium: A Puzzle,”. Journal of Monetary Economics. [Cited by 16 ] (0.68/year)
MEHRA, R. and E.C. PRESCOTT, 2003. The Equity Premium in Retrospect . NBER Working Paper. [Cited by 132 ] (24.36/year)
MEHRA, R. and E.C. PRESCOTT, 1988. The Equity Risk Premium: A Solution? . Journal of Monetary Economics. [Cited by 38 ] (1.86/year)
MEHRA, R. and E.C. PRESCOTT, 1985. The Equity Premium. Journal of Monetary Economics. [Cited by 35 ] (1.49/year)
MEHRA, R. and E.C. PRESCOTT, 1988. The Equity Premium: A Solution?. Journal of Monetary Economics. [Cited by 25 ] (1.22/year)
MEHRA, R. and E.C. PRESCOTT, 1985. The Equity Premium: A Puzzle [J]. Journal of Monetary Economics. [Cited by 21 ] (0.90/year)
MEHRA, R. and N.A.T.I.O.N.A.L. BUREAU, 2003. The Equity Premium: Why is it a Puzzle? . [Cited by 2418 ] (446.17/year)
MELINO, A. and A.X. YANG, 2003. State-dependent preferences can explain the equity premium puzzle . Review of Economic Dynamics. [Cited by 31 ] (5.72/year)
MEYER, D.J. and J. MEYER, 2005. Risk preferences in multi-period consumption models, the equity premium puzzle, and habit formation … . Journal of Monetary Economics. [Cited by 17 ] (4.97/year)
MOSKOWITZ, T.J. and A. VISSING-JORGENSEN, The Private Equity Premium Puzzle . papers.ssrn.com. [Cited by 306 ] (?/year)
NASON, J.M. and B.O.A.R.D. OF, 1988. The Equity Premium and Time-varying Risk Behavior . ideas.repec.org. [Cited by 16 ] (0.78/year)
OTROK, C., B. RAVIKUMAR and C.H. WHITEMAN, 2002. Habit formation: a resolution of the equity premium puzzle? . Journal of Monetary Economics. [Cited by 52 ] (8.10/year)
PANETTA, F., R. VIOLI and B.A.N.C.A. D'ITALIA, 1999. Is there an equity premium puzzle in Italy?: a look at asset returns, consumption and financial … . ideas.repec.org. [Cited by 26 ] (2.76/year)
PASTOR, L. and R.F. STAMBAUGH, 2001. The Equity Premium and Structural Breaks . The Journal of Finance. [Cited by 120 ] (16.17/year)
POLK, C., S. THOMPSON and T. VUOLTEENAHO, 2006. Cross-sectional forecasts of the equity premium . Journal of Financial Economics. [Cited by 46 ] (19.01/year)
POLK, C.K., S.B. THOMPSON and T. VUOLTEENAHO, New Forecasts of the Equity Premium . papers.ssrn.com. [Cited by 16 ] (?/year)
POLKOVNICHENKO, V., 2004. Limited stock market participation and the equity premium . Finance Research Letters. [Cited by 29 ] (6.56/year)
RABIN, M. and R.H. THALER, 2007. Anomalies: Risk Aversion . INTERNATIONAL LIBRARY OF CRITICAL WRITINGS IN ECONOMICS. [Cited by 219 ] (154.28/year)
RAJNISH, M. and E. PRESCOTT, 1985. The Equity Premium: A Puzzle. Journal of Monetary Economics. [Cited by 21 ] (0.90/year)
RIETZ, T.A., 1988. The Equity Premium: A Solution. Journal of Monetary Economics. [Cited by 46 ] (2.25/year)
RIETZ, T.A., 1988. The equity premium puzzle: A solution. Journal of Monetary Economics. [Cited by 21 ] (1.03/year)
SIEGEL, J.J., 1999. The Shrinking Equity Premium (Digest Summary) . Journal of Portfolio Management. [Cited by 120 ] (12.74/year)
SIEGEL, J.J., 1992. The Equity Premium: Stock and Bond Returns Since 1802 . Financial Analysts Journal. [Cited by 96 ] (5.85/year)
SIEGEL, J.J. and R.H. THALER, 1997. Anomalies: The Equity Premium Puzzle . JOURNAL OF ECONOMIC PERSPECTIVES. [Cited by 97 ] (8.49/year)
SIEGEL, J.J. and R.H. THALER, 1997. The Equity Premium Puzzle . The Journal ofEconomic Perspectives. [Cited by 38 ] (3.33/year)
VUOLTEENAHO, T., 2000. Understanding the aggregate book-to-market ratio and its implications to current equity-premium …. Unpublished paper, Harvard University. [Cited by 45 ] (5.34/year)
WEIL, P. and N.A.T.I.O.N.A.L. BUREAU, 1989. The Equity Premium Puzzle and the Riskfree Rate Puzzle . [Cited by 646 ] (33.27/year)
WELCH, I., 2000. Views of Financial Economists on the Equity Premium and on Professional Controversies* . The Journal of Business. [Cited by 145 ] (17.22/year)
WELCH, I., 2000. Views of Financial Economists on the Equity Premium and Other Issues. Journal of Business. [Cited by 30 ] (3.56/year)
WELCH, I.V.O., The Equity Premium Consensus Forecast Revisited . papers.ssrn.com. [Cited by 82 ] (?/year)
YAN, H., 1998. Estimation uncertainty and the equity premium . [Cited by 14 ] (1.34/year)