What is the Equity Premium Puzzle?
Identified by Mehra and Prescott in 1985, this puzzle asks why US stocks have outperformed government bonds by 6-7% annually for over a century. Standard economic models with reasonable risk aversion parameters cannot explain a premium this large. To justify it mathematically, investors would need to be implausibly risk-averse, far more than observed behavior suggests.
Proposed Explanations
Behavioral economics offers the most compelling explanation: myopic loss aversion. Investors evaluate portfolios frequently and feel losses roughly twice as painfully as equivalent gains. This combination of short evaluation horizons and loss aversion makes stocks feel much riskier than their long-term statistics suggest, causing investors to demand an outsized premium. Other explanations include rare disaster risk, survivorship bias in historical data, and liquidity constraints.
What It Means for Long-Term Investors
The equity premium puzzle is good news for patient investors. Because most people cannot tolerate short-term stock volatility, those who can are rewarded with a substantial premium. As long as human loss aversion persists, the structural reason for stocks to outperform bonds remains intact. This does not guarantee future premiums of the same magnitude, but it provides a rational basis for maintaining significant equity exposure over long horizons.