Glossary of economics research
Results of search for equity premium puzzle follow:
equity premium puzzle:
Real returns to investors from the purchases of U.S. government bonds have
been estimated at one percent per year, while real returns from stock
("equity") in U.S. companies have been estimated at seven percent
per year (Kocherlakota, 1996). General utility-based theories of asset prices
have difficulty explaining (or fitting, empirically) why the first rate is so
low and the second rate so high, not only in the U.S. but in other countries
too. The phrase equity premium puzzle comes from the framing of this
problem (why is the difference so great?) and the attention focused on it by
Mehra and Prescott (1985); sometimes the phrase risk free rate puzzle
is used to describe the closely related question: why is the bonds rate so
low? The problem can be inverted to ask: why do investors not reject the
low-returning bonds in order to buy stocks, which would then raise the price
of stocks and lower their subsequent returns?
The above is drawn from the excellent review by Kocherlakota (1996) which
surveys the substantial literature on this subject. Abbreviating further from
it: the theories against which the evidence constitute a "puzzle"
(or paradox, which see) tend to have these aspects in common: (1)
standard preferences described by standard utility functions, (2)
contractually complete asset markets (against possible time- and
state-of-the-world contingencies), and (3) costless asset trading (in terms of
taxes, trading fees, and presumably information).
Overwhelmingly the discussion in the economics literature has focused on
expansions to the formal theory and on refinements and expansions of data
sources, rather than survey evidence. A survey of U.S. households would
answer (has answered?) the question of why they invest so little in
stocks.
[Editorial comment follows.] It is likely (but this is conjecture) that large
fractions of the population do not seriously consider investing in stocks, and
are thus not rejecting stocks because their returns are low, but rather
because they do not know how and think there are some barriers to learning
how; and/or they perceive the risks of stocks to be higher than they have
historically been; and/or they believe their savings are insufficient to
invest. These explanations suggest that as stock trading becomes easier (e.g.
over the Web, with heavy marketing and easy interfaces) the theories will fit
better because more of the population will buy stocks. Indeed, this has been
observed over the last few years. Another class of likely explanations is
that people are highly impatient to spend their income (which would conflict
with standard constant-discount-rate utility functions, but agree with the
evidence; see hyperbolic discounting). Seen this way, the puzzle is
not why the evidence looks the way it does, but the hard theoretical problem
of getting these factors into the asset pricing models.
Source: Kocherlakota, Narayana R. "The equity premium: it's still a
puzzle," Journal of Economic Literature vol XXXIV (March 1996), pp
42-71.
Mehra, Rajnish and Edward C. Prescott. "The equity premium: a
puzzle," Journal of Monetary Economics 15(2) (March 1985), pp
145-161.
Contexts: finance; macro; phrases
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