Sunday, March 12, 2006

The Equity Premium Puzzle

Brad Delong has an excellent summary of what economists call "the equity premium puzzle."

For the uninitiated, the equity premium puzzle refers to the fact that, for the United States, investing in bonds and reinvesting the coupons over a span of twenty years yields significantly less returns than investing in a diversified portfolio of stocks. The simplest explanation is that stocks are riskier than bonds but the problem here is that, making standard assumptions about someone's capacity for risk, you would have to assume people are unrealistically risk-averse to accept the lower yield on bonds in exchange for less risk.

The puzzle comes from the fact that over the long-run, investing in the U.S. stock market really is not very risky at all. I see two possibilities for explaining the equity premium:

1. Economists' standard assumptions about risk-taking behavior are lousy. Very few people have the stomach to watch their net-worth plummet by 5% in one day and not do anything about it. This is a required character trait if you want to succeed in the stock market.
2. People who invest in bonds do not invest in them for returns in the far-off future. They invest in bonds because they want a steady and completely predictable source of income over a long period of time. This is something stocks cannot deliver so people pay a premium for bonds, hence the lower yields. My grandmother, for instance, religiously believed that one should only live off only the interest income of one's investments in retirement. How many people out there are like her?

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