Discussion and Critical Review of the Equity Premium Puzzle
Discussion and critical review of the Equity Premium Puzzle
Introduction
First time this phenomenon was presented by the economists Rajnish Mehra and Edward Prescott in 1985. They discovered that the return from US equity investments in comparison to the return from a risk free government securities had been much far above during the twentieth century to be interpreted by the traditional economic theories (Siegel and Thaler, 1997).
Also, significant research on equity premium puzzle was made by the Siegel. Siegel examined returns on US stocks and fixed income securities starting from year 1802 till 1990. By dividing entire period into three phases 1802 - 1870, 1871 – 1925, 1925 – 1990, he discovered that income from investing in stocks was surprisingly stable, while return on government securities declined considerably during the same time frame. Over three time horizons, real compound returns on stocks were 5.7, 6.6 and 6.4 percent respectively, at the same time as earnings from fixed income securities amounted only 5.1, 3.1 and 0.5 percent (Benartzi and Thaler, 1995). Reviewing data discovered by Siegel, it is becoming obvious that during the last two subperiods income from trading stocks significantly exceeded bonds’, difference reaching almost 6 percent in the final phase.
There were many attempts and researches made to explain the existence of this phenomenon. For several past decades scholars made attempts to explain equity premium puzzle, providing both theoretical and empirical explanations in their researchers. Probable explanations covered imperfections of the markets, empirical concepts such as mean reversion and mean aversion, investors’ behaviours as habit formation and loss aversion and others. First part of this paper will explore theoretical basis of equity premium puzzle, emphasizing attention on heavily discussed myopic loss aversion model.
While one believes in the existence of the equity premium puzzle and tries to solve this
Introduction
First time this phenomenon was presented by the economists Rajnish Mehra and Edward Prescott in 1985. They discovered that the return from US equity investments in comparison to the return from a risk free government securities had been much far above during the twentieth century to be interpreted by the traditional economic theories (Siegel and Thaler, 1997).
Also, significant research on equity premium puzzle was made by the Siegel. Siegel examined returns on US stocks and fixed income securities starting from year 1802 till 1990. By dividing entire period into three phases 1802 - 1870, 1871 – 1925, 1925 – 1990, he discovered that income from investing in stocks was surprisingly stable, while return on government securities declined considerably during the same time frame. Over three time horizons, real compound returns on stocks were 5.7, 6.6 and 6.4 percent respectively, at the same time as earnings from fixed income securities amounted only 5.1, 3.1 and 0.5 percent (Benartzi and Thaler, 1995). Reviewing data discovered by Siegel, it is becoming obvious that during the last two subperiods income from trading stocks significantly exceeded bonds’, difference reaching almost 6 percent in the final phase.
There were many attempts and researches made to explain the existence of this phenomenon. For several past decades scholars made attempts to explain equity premium puzzle, providing both theoretical and empirical explanations in their researchers. Probable explanations covered imperfections of the markets, empirical concepts such as mean reversion and mean aversion, investors’ behaviours as habit formation and loss aversion and others. First part of this paper will explore theoretical basis of equity premium puzzle, emphasizing attention on heavily discussed myopic loss aversion model.
While one believes in the existence of the equity premium puzzle and tries to solve this
References: Benartzi, S. and Thaler, R.H. (1995) "Myopic Loss Aversion and the Equity Premium Puzzle", The Quarterly Journal of Economics, Vol. 110, no. 1, pp 73-92. Berkelaar, A.B., Kouwenberg, R. and Post, T. (2004) "Optimal Portfolio Choice Under Loss Aversion", Review of Economics and Statistics, Vol. 86, no. 4 Cochrane, J.H Dimson, E., Marsh, P., and Staunton, M. (2002) "Long-run Global Capital Market Returns and Risk Premia". London Business School. Dimson, E., Marsh, P., and Staunton, M. (2005) "Global Evidence on The Equity Risk Premium", The Journal of the Applied Corporate Finance, Vol. 15, No. 4, pp. 27-38 Dimson, E., Marsh, P., and Staunton, M Dimson, E., Marsh, P., Staunton, M., Wilmot, J. And McGinnie, P. (2012) "Credit Suisse Global Investment Returns Yearbook 2012", Credit Suisse AG Research Institute. Available Online at: www.credit-suisse.com/researchinstitute Eddings, C Goetzmann, W.N. and Ibbotson R.G. (2006) "Equity Risk Premium: Essays and Explorations", Oxford University Press Hammond, P.B Siegel, J.J. and Thaler, R.H. (1997) "Anomalies: The Equity Premium Puzzle", The Journal of Economic Perspectives, Vol. 11 (1), 191-200. Studenmund, A.H. (2010) "Using Econometrics: A Practical Guide", 6th edition, London: Pearson Education |