 The Equity Premium: Why Is It a Puzzle? (corrected)Financial Analysts Journal, 2003, vol. 59, issue 1, 54-69 Abstract: This article takes a critical look at the equity premium puzzle—the inability of standard intertemporal economic models to rationalize the statistics that have characterized U.S. financial markets over the past century. A summary of historical returns for the United States and other industrialized countries and an overview of the economic construct itself are provided. The intuition behind the discrepancy between model prediction and empirical data is explained. After detailing the research efforts to enhance the model's ability to replicate the empirical data, I argue that the proposed resolutions fail along crucial dimensions. This article provides a critical review of the literature on the equity premium puzzle. As originally articulated more than 15 years ago, this puzzle, underscored the inability of the standard paradigm of economics and finance to explain the magnitude of the risk premium—the return earned by a risky asset in excess of the return to a relatively riskless asset.I summarize the historical experience of the United States and other industrialized countries and detail the intuition behind the discrepancy between model prediction and empirical data. The discussion addresses various research approaches that have been proposed to enhance the model's realism. One set of solutions to the equity premium puzzle advises that researchers consider alternative preference structures to the classic structure. Within this set, some researchers have called for modifying the conventional time-and-state-separable utility function, and a second group approaches the problem by adding the concept of habit formation. Yet other approaches link the puzzle to the presence of idiosyncratic and uninsurable income risk that investors face or to investors' perceiving a small probability of disaster. Another attempt to resolve the puzzle posits that the realized returns reflect the premium in the United States on a stock market that has successfully weathered the vicissitudes of fluctuating financial fortunes. Some models incorporate borrowing constraints on young people, who would be the most likely to accept risky assets at less of a premium than is observed; other models view the premium as a transaction-facilitating service “fee.” Finally, a group of models relates the premium to changes in tax rates.While reviewing these major directions in theoretical financial research, I point out the ways in which the majority of the proposed resolutions fail along crucial dimensions. I also note that how one views the equity premium depends on whether one is talking about the observed, realized premium (which has remained fairly consistent over long horizons) or the expected short-term premium (which can vary considerably). Date: 2003 Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:taf:ufajxx:v:59:y:2003:i:1:p:54-69 Ordering information: This journal article can be ordered from Access Statistics for this article Financial Analysts Journal is currently edited by Maryann Dupes More articles in Financial Analysts Journal from Taylor & Francis Journals |
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