Equity Premium Puzzle (EPP)

What is the Equity Premium Puzzle?

The Equity Premium Puzzle (EPP) describes the historically large excess return that U.S. stocks have delivered over short‑term Treasury bills. Measured as the equity risk premium (equity returns minus Treasury bill returns), this gap has averaged roughly 5%–8% historically. The puzzle arises because that size of premium implies implausibly high levels of investor risk aversion under standard economic models.

Historical context

• The term was formalized by Rajnish Mehra and Edward C. Prescott in 1985.
• The premium has varied over time: roughly 5% in the first half of the 20th century and over 8% in the second half.
• Several historical factors likely contributed to this variation, including the gold standard (which limited inflationary effects on government securities), changing stock valuations, and demographic trends.

Proposed explanations

Economists and behavioral researchers have proposed many hypotheses to account for the EPP. Key ideas include:

• Behavioral factors
• Prospect theory (Kahneman & Tversky): investors’ loss aversion and reference-dependent preferences can distort pricing and raise required returns on equities.
• Measurement and valuation issues
• Dividend yields and total return obscured by focus on price movements: early underappreciation of dividend income may have increased realized equity returns as investors learned to value dividends.
• Stock‑market valuation cycles (e.g., long‑run P/E levels) affect expected future returns and the observed historical premium.
• Risk and “risk‑free” asset definition
• Treasury bills are not truly risk‑free in all senses (inflation, currency debasement, defaults). Measured against other benchmarks such as gold, the premium shrinks.
• Aggregation and diversification
• Individual stocks are much riskier than the diversified market. Historically, many investors held concentrated holdings and were compensated for idiosyncratic risks that later diversification reduced.
• Macroeconomic and demographic drivers
• Population growth and expanding markets boosted corporate growth during the 20th century; declining populations in some countries have coincided with weaker equity returns.
• Market frictions and institutions
• Taxes, transaction costs, liquidity considerations, regulatory environments, and the prevalence of personal debt can all change investors’ required returns and partially explain the premium.

Special considerations and implications

• Durability: The equity premium is not a fixed law; it varies with valuation levels, economic regimes, demographics, and investor beliefs. A period of rising valuation levels can lower future expected stock returns.
• Asset allocation: The EPP influences long‑term investment decisions, retirement planning, and the equity risk premium assumptions used in financial models. Overestimating the premium can lead to overly aggressive portfolios.
• Benchmark choice matters: Which asset is treated as “risk‑free” affects the measured premium; using currencies or other assets as alternatives can change conclusions.
• Historical reward: Regardless of the explanation, investors who held U.S. equities historically were substantially rewarded relative to short‑term Treasury bills.

Key takeaways

• The EPP highlights a persistent, historically large gap between stock returns and Treasury bill returns that standard models struggle to justify.
• Multiple, complementary explanations exist—behavioral biases, measurement issues, changing valuations, demographics, and institutional frictions—rather than a single definitive cause.
• Understanding the EPP matters for realistic return assumptions, portfolio construction, and expectations about future equity performance.