Equity Premium


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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"
Montier (2002) page 23

"...the equity premium, the extra return that people require to be compensated for the risk of investing in the stock market..."
Shiller (2000) [book]

Possible explanations of the equity premium puzzle:

  1. The puzzle is an illusion: the empirical data are wrong
  2. High risk aversion
  3. Nonstandard utility functions
  4. Autocorrelation in returns
  5. Time varying expected returns
  6. Heterogeneous investors
Or, more likely, a mixture of the above.


Top 10 Papers

  1. 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)
  2. CONSTANTINIDES, G.M., 1990. Habit Formation: A Resolution of the Equity Premium Puzzle. Journal of Political Economy. [Cited by 961] (52.17/year)
  3. BENARTZI, S. and R.H. THALER, 1993. Myopic Loss Aversion and the Equity Premium Puzzle. NBER Working Paper. [Cited by 879] (57.01/year)
  4. 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)
  5. … 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)
  6. MOSKOWITZ, T.J. and A. VISSING-JORGENSEN, The Private Equity Premium Puzzle. papers.ssrn.com. [Cited by 306] (?/year)
  7. FAMA, E.F. and K.R. FRENCH, 2002. The Equity Premium. The Journal of Finance. [Cited by 346] (53.90/year)
  8. MANKIW, N.G., 1987. The Equity Premium and the Concentration of Aggregate Shocks. NBER Working Paper. [Cited by 188] (8.78/year)
  9. SIEGEL, J.J., 1999. The Shrinking Equity Premium (Digest Summary). Journal of Portfolio Management. [Cited by 120] (12.74/year)
  10. 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)