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What Is the Equity Premium Puzzle?

The equity premium puzzle is a situation in which the real returns on stock issues are substantially higher than the returns on government bonds.
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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 23 November 2014
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The equity premium puzzle is a situation in which the real returns on stock issues are substantially higher than the returns on government bonds. One of the confusing aspects of the puzzle is that some financial experts claim that the puzzle does not really exist at all, while others see this is a true phenomenon but do not agree on the reasons for this type of activity. As such, the equity premium puzzle represents something of an ongoing mystery that is not likely to be settled in the near future.

For those who see the equity premium puzzle as a true mystery, the process begins by defining what constitutes an equity premium that is well above the average. This begins by understanding that an equity premium is the equity returns less the amount of bond returns generated within a specified period of time. The difference is usually expressed as a percentage. In the United States, this percentage is normally set at 6%, although some analysts believe that figure is too high.

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Financial experts who deny the existence of an equity premium puzzle do not deny there are periods when the difference between stock returns and returns on government bonds fluctuate, sometimes to unusually high levels. What they do deny is that there is any real mystery at all. Those who approach equity premium fluctuations in this manner see the activity as normal responses to events that occur within the marketplace from time to time. From this perspective, the activity is to be expected and does not constitute anything that should be considered out of the ordinary.

Regardless of the stance on whether this fluctuation is a mystery or not, there are several theories on what may lead to situations that some choose to term an equity premium puzzle. Among these are factors that impact the expected return on bonds or investments. This may include perceptions of investors regarding the potential impact of political issues, new technology, or consumer demand on certain key investment types. Others believe that one possible origin of the puzzle is the fact that a model of risk aversion that is currently held as a standard is flawed, and should be adjusted to accommodate current data. At present, there is no universal set of explanations for why an equity premium puzzle may exist, even as there is no universal agreement on whether the puzzle is a real phenomenon or simply an artificial construct derived by the arrangement of statistics.

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