The equity premium puzzle is a term used to describe the fact that, over long periods of time, stocks have outperformed other investments such as bonds. This outperformance is often referred to as the equity risk premium. The equity premium puzzle is a bit of a mystery because it is not clear why stocks should outperform other investments by such a large margin. Many theories have been proposed to explain the equity premium puzzle, but no single theory has been able to completely explain it.
What is equity risk premium?
The equity risk premium is the difference between the expected return on a stock and the risk-free rate. The risk-free rate is the return on a investment with no risk, such as a government bond. The equity risk premium is the compensation that investors require for taking on the risk of investing in stocks.
There are a number of ways to estimate the equity risk premium. One popular method is to look at the historical average return on stocks minus the historical average return on government bonds. This approach has a number of drawbacks, however, including the fact that it only looks at the past and does not account for future expected returns.
Another approach is to look at the earnings yield on stocks minus the yield on government bonds. The earnings yield is the inverse of the price-to-earnings ratio and measures the percentage of a company's earnings that are returned to shareholders. This approach has the advantage of being forward-looking, but it can be volatile and may not be representative of the true risk of stocks.
Ultimately, there is no one right answer to the question of what the equity risk premium is. It will vary over time and from investor to investor. What is equity risk premium formula? The equity risk premium (ERP) is the difference between the expected return on a stock and the risk-free rate. The formula for calculating the ERP is:
ERP = E(R_s) - R_f
Where:
E(R_s) = expected return on a stock
R_f = risk-free rate
How does prospect theory explain Equity Premium Puzzle?
Prospect theory is a behavioral finance theory that was developed by Kahneman and Tversky in 1979. It posits that people make decisions based on the perceived likelihood of different outcomes, rather than the actual likelihood. This can lead to suboptimal decisions, as people may overweight the likelihood of low-probability events.
One implication of prospect theory is that people may be risk-averse when it comes to gains, but risk-seeking when it comes to losses. This means that people are more likely to investment in stocks when the stock market is down, in the hopes of making a quick profit, but are less likely to invest when the stock market is up. This behavior can lead to the equity premium puzzle, which is the finding that stocks have higher expected returns than risk-free assets.
There are a number of possible explanations for the equity premium puzzle, but prospect theory provides one explanation for why it might exist.
How can myopic loss aversion explain the equity premium puzzle?
Assuming that myopic loss aversion is the only thing driving investor behavior, the equity premium puzzle can be explained as follows:
Investors are myopic, meaning that they focus on the short-term. They are also loss averse, meaning that they are more risk-averse when it comes to losses than gains.
This combination of factors leads investors to demand a higher return on stocks than on other investments, such as bonds. The higher return compensates them for the higher risk of losses in the stock market.
Over time, this higher return on stocks results in a higher average return for the stock market as a whole. This higher average return is known as the equity premium. What is equity premium myopia? Equity premium myopia is the tendency for investors to focus too much on the potential upside of stocks while neglecting the potential downside. This can lead to taking on too much risk and ultimately losing money.