Equity Premium Puzzle

Equity Premium Puzzle ( German Securities premium puzzle) is a 1985 book published by Rajnish Mehra and Edward C. Prescott paradox of finance. It consists in a accordance with economic theory excessive difference between the returns on risky securities (mainly equities) and those that are considered to be relatively safe (eg government bonds). Although economic theory predicts the existence of a difference between these two categories of securities on the assumption of risk aversion, the extent of which is in contradiction with theoretical predictions.

Empirical data

Empirical studies have shown that the difference between the yields of affected securities risk and safe is about 3 to 4 percentage points on average. Transferred to the traditional economic model of risk aversion would mean that an average individual is indifferent one hand between a secure payment of $ 51,209 and a 50/50 lottery on the other hand, in the amount of the possible income 50,000 and $ 100,000. This is much more extreme than the normally observable human behavior and not only be explained by risk aversion.

Explanations

There have been many attempts to explain the equity premium puzzle has been submitted, their common goal is to bring the empirical observations in relation to the risk premium on securities with economic theory consistent.

Risk and loss aversion

One category of explanation attempts to reinterpret or expand, so that the equity premium puzzle would no longer seem paradoxical, the theoretical modeling of risk aversion. This category includes, inter alia, attempts to model the benefit of investors than usual depending on other parameters. A similar approach is the introduction of the concept of loss aversion - according to him people should be particularly strongly bound to the values ​​they already possess, and consequently weigh very much their loss. Both of these approaches is beyond the scope of neoclassical theory.

Transaction costs

A proposed by Gregory Mankiw and Stephen Zeldes interpretation of the Equity Premium Puzzle emphasizes the fact that most people are not active on financial markets - due to unspecified transaction costs. Thus loses the standard model of the representative agent, which is used in the financial economics, his fortune, to reflect reality faithfully. Seen in the equity premium puzzle would be merely the result of unfounded application of this model.

Financial disasters

Some economists, including Robert Barro and Martin Weitzman, proposed the following interpretation before: As the financial markets are a relatively new phenomenon in its present form, it could be that a rational actor frequent breakdowns in these markets expected, as they historically been could observe. Thus, the subjectively perceived by the market operators risk of investing in stocks etc. would be higher than one would expect on the basis of time series data on financial market development. Benoît Mandelbrot argues in his book Fractals and finance, so that the deviation is justified that stock markets would not follow a normal distribution, but a heavy- tailed distribution, whereby extreme losses are much more likely, as is assumed in the standard theories. The increased possibility of a substantial loss or financial ruin, justifying the higher yield.

Learners investors

The risk premium on risky securities was loud empirical studies higher at the beginning of the 20th century and gradually decreased with time. The lay close according to some economists, an explanation of the equity premium puzzle, which is based on the assumption that people have to learn to deal with new social constructs. Accordingly needed financial actors a century to learn the true parameters of the statistical distribution of securities prices. The fact that the learning process takes so long, it was up to institutional barriers. According to this interpretation is to be expected that the equity premium puzzle dissolves over time itself.

Swell

• Rajnish Mehra, Edward C. Prescott: The Equity Premium: A Puzzle. In: Journal of Monetary Economics. No. 15, 1985, p 145-161 ( academicwebpages.com (PDF, 779 kB) ).
• Bradford De Long, Konstantin Magin: The U.S. Equity Return Premium: Its Past, Present, and Future. In: Journal of Economic Perspectives. 23, No. 1, 2009, pp. 193-208 ( available online (PDF, 232 kB) ).