The Equity Premium Puzzle

One of the great puzzles of finance is the “equity risk premium.” This refers to the fact that stocks have historically outperformed bonds. Not only that, they’ve outperformed them by a lot. Finance professors aren’t exactly sure why.
According to Wikipedia:

A large number of explanations for the puzzle have been proposed. These include a contention that the puzzle is a statistical illusion, modifications to the assumed preferences of investors and imperfections. Kocherlakota (1996) presents a detailed analysis of these explanation in financial markets and concludes that the puzzle is real and remains unexplained. Subsequent reviews of the literature have similarly found no agreed resolution.
An alternative explanation for the puzzle has been proposed by Benartzi and Thaler (1995). Applying prospect theory they contend that myopic loss aversion provides a plausible solution to the puzzle. They assert that investors evaluate their portfolio in a relatively short sighted way and that, as loss aversion implies, they are highly sensitive to losses over this time period. The evaluation time period implied in their model by an equity premium of 6 percentage points and a 2x loss aversion multiplier (a general finding of loss aversion research) is approximately one year. This explanation does seem consistent with the data and has not, to date, been rebutted. However, in the absence of a general model of portfolio choice and asset valuation for prospect theory it has not received general acceptance.

I believe the answer is really quite simple. Stocks have to perform better than bonds. If they didn’t, all of capitalism would come crashing down. A bond is a loan, and a stock is equity, meaning it’s what you do with the loan. In that relationship, there’s an implicit agreement that the borrower will make more money than the lender, otherwise the former wouldn’t borrow and the latter wouldn’t lend. The difference is the equity premium.
Well, that’s my theory. Now Australian Professor Peter Swan has a new theory. He thinks the equity premium puzzle is due to liquidity:

In a working paper titled, “Can Illiquidity Explain the Equity Premium Puzzle?”, Prof Swan said that equity markets are highly illiquid compared to government securities such as bonds.
“My contribution to (the puzzle) is that we can’t just look at the direct impact of transaction costs on returns,” he said.
“We have to look at the indirect impact in terms of interfering with our ability to achieve desirable risk minimising portfolios.”
Prof Swan added: “When you take into account indirect effects it would appear that even in small transaction costs do seem explain much of the equity premium puzzle, and a variety of other puzzles as well.”
His model illustrates that the equity premium is no more than compensation to equity holders for the adverse effects of illiquidity.
Prof Swan’s work also helps account for the term “irrational exuberance”, a phrase coined by the US Federal Reserve chairman Alan Greenspan.
According to Robert Shiller, of the Cowles Foundation for Research in Economics and International Center for Finance at Yale University, the term “irrational exuberance” is often used to describe a heightened state of speculative fever.
“What this is referring to is the high volatility observed in asset prices … the big booms and the crashes we see in stock prices which are not nearly as prevalent in government securities,” said Prof Swan.
“This is not easily explained within the standard finance paradigm, which states that the price of any stock depends on its expected dividends or earnings.”
Prof Swan provides a theory for why stock prices are so volatile when dividends are stable and earnings are relatively stable.
“The biggest benefit of all is from the security that is associated with volatility in the returns and prices for the stock,” he said.
“We no longer need the new field of behavioural finance to explain excess volatility.”

I’m not so sure we can ditch it just yet. Certainly, transactions costs play a role, and I think Professor Swan adds an important angle to the debate. However, I can’t help but notice that often the most volatile stocks are the most liquid ones. Who care about a penny spread on Google at $465? A modern investor can invest in something basically resembling “the market” pretty easily. Is it really that much more illiquid? I don’t know but I hope we’ll see more research on this issue.

Posted by on January 5th, 2006 at 2:32 pm


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