Understanding the Equity Premium Puzzle: A Deep Dive

The Equity Premium Puzzle (EPP) refers to the fact that stocks have outperformed Treasury bonds by an extraordinarily high margin over the last century – a margin so high that it is very difficult to explain regardless of how thoroughly the situation is analyzed. EPP is one of the many widely researched mysteries in the world of finance and investment.

Summary

• The Equity Premium Puzzle (EPP) refers to the fact that stocks have outperformed Treasury bonds by an extraordinarily high margin over the last century – a margin so high that it is very difficult to explain regardless of how thoroughly the situation is analyzed.
• The equity premium is the difference between the returns earned on equity investments and the returns earned on bond investments.
• The equity premium is regarded as a puzzle because it is very difficult to explain how the returns on equities have been significantly higher on an average, compared to the returns on Treasury bonds, based upon investor risk aversion.

What is the Equity Premium?

The equity premium, simply explained, is the difference between the returns earned on equity investments and the returns earned on bond investments, i.e.:

Equity Premium = Equity Returns – Bond Returns

The equity premium over the last century has, on average, been approximately 6%, which is an indicator of an extraordinarily significant outperformance of equity over Treasury bonds and is a major mystery puzzle in the world of finance and investment.

Understanding the Equity Premium Puzzle

In the world of finance and investment, one significant principle is that higher risk offers greater rewards. Since equity stocks are riskier securities, they provide higher returns. Why is it considered to be a puzzle, then?

While it is true that higher risk earns a higher return, and it is one of the foundational concepts of finance and investment, the equity premium puzzle is still a major mystery. It is because while a greater return is expected, as compensation for the higher element of risk, a greater return of equity stocks of perhaps about 1% over bond returns would be expected.

The primary source of the puzzle is the size of the equity premium. An approximately 6%-8% of equity premium over the past century is an extraordinarily huge outperformance. It overcompensates the equity investor based on the relative level of risk they assume compared to investing in risk-free government bonds.

Equities vs. Government Securities

Treasury bonds are government securities. Since they are government securities, there is guaranteed repayment, as the government is not expected to default. Since there is a 100% certainty of repayment and basically no expectation of a default, it is considered a risk-free security because the risk of default is entirely eliminated.

On the other hand, equity stocks are a higher-risk security because the returns on the equity stocks will depend on how well the stock is doing in the market. The market is an extremely volatile place, and with volatilityVolatilityVolatility is a measure of the rate of fluctuations in the price of a security over time. It indicates the level of risk associated with the price changes of a security. Investors and traders calculate the volatility of a security to assess past variations in the prices comes risk, because there is a level of uncertainty involved with regards to its returns.

Since Treasury bonds are risk-free securities, they are expected to be a safer investment with more stable and safer returns. However, over the years, equity stocks have proven to earn much higher returns compared to Treasury bonds, even with the high element of risk involved. It creates a puzzle as there is no way to explain the extraordinarily significant outperformance of equity stocks over treasury bonds, considering the element of risk and volatility involved.

It is why equity premium is regarded as a puzzle because it is very difficult to explain how the returns on equities have been significantly higher, on average, than the returns on Treasury bonds.

More Resources

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