What is the Equity Premium Puzzle (EPP)?

What is the Equity Premium Puzzle (EPP)?

The equity premium puzzle (EPP) refers to the excessively high historical outperformance of stocks over Treasury bills, which is difficult to explain. The equity risk premium, which is usually defined as equity returns minus the return of Treasury bills, is estimated to be between 5% and 8% in the United States.

The premium is supposed to reflect the relative risk of stocks compared to “risk-free” government securities. However, the puzzle arises because this unexpectedly large percentage implies an unreasonably high level of risk aversion among investors.

introduction of Equity Premium Puzzle

In the world of finance and investment, one significant principle is that higher risk offers greater rewards. Since equity stocks are riskier securities, they provide higher returns. Why is it considered to be a puzzle, then?

While it is true that higher risk earns a higher return, and it is one of the foundational concepts of finance and investment, the equity premium puzzle is still a major mystery. It is because while a greater return is expected, as compensation for the higher element of risk, a greater return of equity stocks of perhaps about 1% over bond returns would be expected.

The primary source of the puzzle is the size of the equity premium. An approximately 6%-8% of equity premium over the past century is an extraordinarily huge outperformance. It overcompensates the equity investor based on the relative level of risk they assume compared to investing in risk-free government bonds.

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