Funny Futures
The equity premium puzzle is one of the longest standing anomalies in finance: the finding that stockmarket investing outperforms other types of investment by a significant amount. Generally you'd expect the price of shares to rise until this advantage was cancelled out, but this hasn't happened and has made quite a lot of futurologists look rather silly.
It turns out, though, that the equity premium puzzle may be even more puzzling than it first appears. Basically researchers aren't exactly sure how large it is, or even if it exists at all. So is the idea that stocks always outperform other investments in the long run just another market myth used to cajole unwary investors into parting with their hard-earned cash?
Witless Aversion
The puzzle was first noted by Rajnish Mehra and Edward Prescott in 1985. They pointed out that:"Historically the average return on equity has far exceeded the average return on short-term virtually default-free debt. Over the ninety-year period 1889-1978 the average real annual yield on the Standard and Poor 500 Index was seven percent, while the average yield on short-term debt was less than one percent".The value they arrived at is disputed, as we'll see below, but the general problem was that if standard conditions of competition between asset classes apply then this kind of premium doesn't make any sense. If the risk-free asset – a government bond – is returning 1% then you'd expect equity returns to fall to the same level plus a bit of extra return for the additional risk. In order for stocks to return 6% more than the risk free asset then investors need to be incredibly risk adverse – essentially scared witless – about the possibility of losing their money. This, reckon most observers, is implausible.
The Importance of the Equity Premium
Now this 6% premium and 7% inflation adjusted return is why most investing advice pushes the ideas of stocks over less risky assets such as bonds and cash. Equities are more volatile – that is, their prices vary much more – but over the long-run a 6% premium builds up to an enormous difference in the terminal value of your investments. So we've gravitated to a default position that younger people with time to run to retirement should invest mainly in stocks and that they should do so with…
