Behavioral Finance

CHAPTER 18

The Equity Premium Puzzle

A riskless asset should have the lowest market yield. Taxes can distort this simple proposition, but the tax treatment between three-month U.S. Treasury bills and common stock is the same, so that it is natural to expect that three-month U.S. Treasury bills will return, over time, much less for its owner than a diversified portfolio of common stocks. If an individual stock has an expected return of ∏, while three month treasuries have an expected return of ρ, then we define the risk premium of a single stock as:

(18.1)

If we now consider an index1 of all stocks taken together, we can define the expected return of the index as δ, and the equity premium is defined as:

(18.2)

In other words, the equity premium is how much a diversified portfolio of stocks is expected to earn above and beyond the returns expected from a risk-free asset.

MEHRA AND PRESCOTT

In 1985, Mehra and Prescott2 combined empiricism and economic theory to conclude that the equity premium observed in historical stock prices was simply too large. Mehra and Prescott looked at a 90-year period of stock returns, 1889 to 1978, and estimated the average stock return, corrected for inflation, to be 6.98 percent. Similarly, they calculated that an “average real return on relatively riskless, ...