Are stock returns too high?

A fast look at the equity risk premium "puzzle". This "puzzle" was laid out by Mehra and Prescott in their 1985 paper. Essentially it says that the risk premium of stocks is higher than should be expected for any "reasonable" level of risk aversion. The solution that seems to make the most sense is that investors are very very concerned about losses and less concerned about gains: which is prospect theory.

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    Equity premium puzzle

    Nothing new here, but does have a list of possible explanations (and a reminder that not everyone believes there is a puzzle). The equity premium puzzle is a term coined in 1985 by Rajnish Mehra and Edward C. Prescott in their seminal work of the same name, and refers to a lack of consensus among economists on why demand for government bonds-which return much less than stocks-is as high as it is, and even why the demand exists at all.

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    Equity Premium Puzzle - EPP

    An phenomenon that describes the anomalously higher historical real returns of stocks over government bonds. The equity premium, which is defined as equity returns less bond returns, has been about 6% on average for the past century.

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    The Equity Premium Puzzle and Its Possible Explanations , Roberto Pancrazi

    Imagine that you were a little child receiving $100 from your grandmother in 1946. Suppose also, that you were a wanna-be economist who tried to do the best long-run investment decision at the very early stage of your life.

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    Siegel and Thaler together. Need I say more?

    Great stuff.

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    Fama and French on the premium

    Short version? they believe investors now demand a lower return than a century ago and the price appreciation that accompanied this new lower return (remember to get expected returns down, price -which is in the denominator-must go up), is the cause of the puzzle and as such not likely to continue. PERSONAL take: I disagree in part, but do agree with their conclusion that the risk premium will likely be lower in the future and as such, we can not assume AS high of returns merely from holding stocks for a long time.

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    My favorite academic paper on the puzzle

    By Mehra himself but two decades after the original. This serves as a great review of the literature on the puzzle as well as an update of the size of the premium.

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    My favorite explanation of the size of the risk premium: prospect theory

    Imagine a world where investors (even long term investors), are petrified of losses (even paper losses). They then demand a high return for taking on this risk. It should be mentioned that this risk appears to disappear if the investor looks long term, but in fact some does not disappear. One "solution" to this claimed irrationality is to look at your portfolio less often (if you look daily, you feel the pain more often). Another way, which I see in many investors (and on the boards I work with) is to remind yourself not what the portfolio value was just before, but since inception etc. This gives you a mental picture of "we are up x%", rather than "we lost 10,000 dollars today" even though both are true.

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