The u.s. Eq. Premium puzzle

Question 1

• “the equity premium puzzle”

Answer 1

diversified long-horizon investments in America’s stock market have received much higher returns than investors in bonds: higher long run average returns with no more risk.

Question 2

• Possible explanations of puzzle

Answer 2

\: implications of risk aversion
nonstandard preferences
 transaction costs
 lower-tail risk; persistent mistakes
 investor confusion
cognitive biases

Question 3

1. High risk aversion as explanation of puzzle

Answer 3

Rational investors prefer the portfolios they hold => but the degree of risk aversion needed to support the existing equity return premium seems extremely high. Also, a high degree of risk aversion should guarantee a high risk-free rate or return, but in our case the risk-free rate is low – again puzzle (explains the high risk premium, but then why the risk-free rate is so low)

Question 4

2. Behavioural finance explanation:

Answer 4

“loss aversion”
“Ambiguity aversion”
“myopia”

Question 5

“loss aversion”

Answer 5

the pain from loss is bigger than the pleasure from gain, thus, investors need a high risk premium.

Question 6

“Ambiguity aversion”

Answer 6

– investors do not know the distribution of a stock market for sure, thus, they require a high equity premium- stock market is like a gamble.

Question 7

“myopia”

Answer 7

investors find it difficult to discount appropriately, and they pay too much attention to the high short term risk of equities.

Question 8

Transaction costs & investor heterogeneity - as explanation of the puzzle

Answer 8

• EPP may appear in form of borrowing constraints. The relative young (who have the option to go bankrupt) have difficulty borrowing on large scale; blocked from making big investment in early life.
• Investors are subject to idiosyncratic income shocks that are correlated with returns on equities. Thus, investors bear a large amount of equity risk embedded in their human capital in their total implicit portfolio, so they don’t want to take further risks in their explicit financial portfolios.

Question 9

4. Lower-tail risk? - as explanation of the puzzle

Answer 9

• Some researchers argue that if there was a long enough sample, there would be a sufficient number of collapses in stock (economic catastrophes) and consumption values, so that the equity premium wouldn’t be a puzzle anymore. But it is strange: the collapse should be large enough to create the equity premium, but small enough to leave a positive interest rate safe => very unlikely. Moreover, the crisis should diminish the value of stocks, but not bonds or T-bills.

Question 10

5. Learning about the return distribution - As explanation of the puzzle

Answer 10

• The misperception that equity returns are risky created the equity premium => now investors learn that they are not so risky, and the prices of stocks have boosted.

Question 11

The Future of the equity premium

Answer 11

• Economists still don’t have a complete explanation of EPP.
• Fama & French propose that EEP was generated by initial pisperceptions and is corrected by learning; today’s dividend’s yield and the average growth rate of dividends shall be used to forecast the exp equity risk premium, but it will be biased downwards, as the firms have substituted stock buybacks for dividends in the past years.
• Eq premium is likely to persist in the future, as long as investors are the same “risk averse” or “loss averse” , but at lower size (perhaps 4% a year rather than historical 6%).
• Institutional changes have occurred, the memory of the Great Depression faded away, so it seems logical that these developments will not make the eq risk premium to go forward.
• Eq premium will continue, but at a lower level. The risk-bearing capacity of society is not being fully utilized yet.

Question 12

2 situations in the article

Answer 12

1) Invest in a diversified portfolio of equities, reinvest payouts and maintain diversification.
2) Invest in short-term Treasury Bills