Equity Premium Puzzle

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Equity Premium Puzzle is a paradox published in 1985 by Rajnish Mehra and Edward C. Prescott that occurs in financial markets. There is, according to economic theory, an excessively large difference between the returns on high-risk securities (especially stocks ) and those that are considered relatively safe (e.g. government bonds ). Although economic theory predicts the existence of a difference between these two categories of securities based on the assumption of risk aversion , its magnitude contradicts theoretical predictions.

Empirical data

Empirical research has shown that the difference between the returns on risky and safe securities averages around 3 to 4 percentage points . Applied to the traditional economic model of risk aversion, this would mean that the average individual is indifferent between a secure payout of $ 51,209 on the one hand and a 50/50 lottery on the other, where the potential returns are $ 50,000 and $ 100,000. This is significantly more extreme than the normally observable human behavior and can only no longer be explained by risk aversion.

Explanatory approaches

Many approaches have been put forward to explain the Equity Premium Puzzle, the common goal of which is to reconcile the empirical observations regarding the risk premium in securities with economic theory.

Risk and loss aversion

One category of explanation tries to reinterpret or expand the theoretical modeling of risk aversion so that the equity premium puzzle would no longer appear paradoxical. This category includes a. Try to model investor utility on other parameters than usual. A similar approach is the introduction of the term loss aversion - according to it, people should be particularly tied to values ​​that they already have and consequently weight their loss very strongly. Both approaches go beyond the scope of neoclassical theory .

Transaction costs

An interpretation of the Equity Premium Puzzle proposed by Gregory Mankiw and Stephen Zeldes emphasizes the fact that most people are not active in financial markets - due to unspecified transaction costs . Thus the standard model of the representative agent , which is used in financial economics, loses its ability to correctly represent reality. Seen in this way, the Equity Premium Puzzle would simply be the result of the unfounded application of this model.

Financial disasters

Some economists, including Robert Barro and Martin Weitzman , suggested the following interpretation: Since financial markets in their present form are a relatively new phenomenon, a rational actor may expect more frequent collapses in these markets than has historically been the case could watch. This means that the risk of investing in stocks , etc. subjectively perceived by market players would be higher than one would expect on the basis of time series data on financial market developments. Benoît Mandelbrot argues in his book Fractals and Finances that the deviation can be justified by the fact that stock markets do not follow a normal distribution but a heavy-tailed distribution , which makes extreme losses much more likely than is assumed in standard theories. The increased possibility of substantial loss or financial ruin therefore justifies the higher yield.

Learning investors

According to empirical studies, the risk premium on risky securities was higher at the beginning of the 20th century and gradually decreased over time. According to some economists, this suggests an explanation of the Equity Premium Puzzle, which is based on the assumption that people have to learn to deal with new social constructs. As a result, it took financial actors a century to learn the true parameters of the statistical distribution of security prices. The fact that the learning process takes so long is due to institutional barriers. According to this interpretation, the Equity Premium Puzzle can be expected to resolve itself over time.

swell

  • Rajnish Mehra, Edward C. Prescott : The Equity Premium: A Puzzle . In: Journal of Monetary Economics . No. 15 , 1985, pp. 145–161 ( PDF; 779 kB ).
  • Rajnish Mehra, Edward C. Prescott: The equity premium in retrospect . In: NBER Working Paper . Cambridge, MA 2003 ( PDF; 291 kB ).
  • Bradford De Long, Konstantin Magin: The US Equity Return Premium: Its Past, Present, and Future . In: Journal of Economic Perspectives . tape 23 , no. 1 , 2009, p. 193-208 ( PDF; 232 kB ).

Individual evidence

  1. ^ Gregory N. Mankiw and Stephen Zeldes: The Consumption of Stockholders and Nonstockholders . In: Journal of Financial Economics . tape 29 , no. 1 , 1991, p. 97-112 .
  2. ↑ Benoît Mandelbrot: Fractals and finance: markets between risk, return and ruin . 2007, ISBN 3-492-04632-0 , pp. 315 ff .