Why is the equity premium a puzzle?
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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.
Kocherlakota (1996), Mehra and Prescott (2003) present a detailed analysis of these explanations in financial markets and conclude that the puzzle is real and remains unexplained. Subsequent reviews of the literature have similarly found no agreed resolution.
What is the equity premium in finance?
An equity risk premium is an excess return earned by an investor when they invest in the stock market over a risk-free rate. This return compensates investors for taking on the higher risk of equity investing. Calculating an equity risk premium requires using historical rates of return.
How prospect theory explains the equity premium puzzle?
Recent research on prospect theory has shown that it is applicable in finance, insurance, and other areas. Prospect theory can explain such financial phenomena as the equity risk premium puzzle, the lower long-term average returns of IPOs, and the lack of diversification in many household portfolios.
What is the volatility puzzle?
Finance textbooks say that more volatile assets should have higher returns. The volatility puzzle is that that doesn’t always hold true. A five-year window was used to find the volatility of each of the stocks. For each month the volatility was broken into quintiles.
What is the risk free rate puzzle?
The risk-free rate puzzle (RFRP) is a market anomaly observed in the persistent difference between the lower historic real returns of government bonds compared to equities. This puzzle is the inverse of the equity premium puzzle and looks at the disparity from the perspective of the lower returning government bonds.
How can loss aversion explain the equity risk premium?
One of the most robust predictions of loss aversion is a sizeable equity premium in an equilibrium model. Loss aversion means that investors are more sensitive to losses than to gains. Since stocks often perform poorly and thus investors often face losses, a large premium is required to convince them to hold stocks.”
Where do I find equity premium?
The equity risk premium is calculated as the difference between the estimated real return on stocks and the estimated real return on safe bonds—that is, by subtracting the risk-free return from the expected asset return (the model makes a key assumption that current valuation multiples are roughly correct).
Calculating the Risk Premium of the Market
- Estimate the expected total return on stocks.
- Estimate the expected risk-free rate of return.
- Subtract the expected risk-free rate from the expected market return.
- Take the average return on the market and on the stock for a period of years.
One behavioral theory by Shlomo Benartzi and Richard Thaler attributes the equity premium puzzle to what’s known as myopic loss aversion (MLA) – the idea that loss-averse investors (as all investors are) take too short-term a view of their investments, leading them to react overly negatively to short-term losses.
How can myopic loss-aversion explain the equity premium puzzle?
We find that the puzzle can be explained by assuming that investors are loss averse, meaning that a loss hurts them twice as much as a gain pleases them, and that they are myopic in their investment strategy, meaning that they on average evaluate their portfolios too often.
What is excessive volatility?
Excess volatility is the name given to that level of volatility over and above that which is predicted by efficient market theorists. In Shiller’s eyes this excess volatility can be attributed to investors’ psychological behaviour.