Abstract
The model proposed in this paper explains the equity premium puzzle using a simple survival-based principle of rationality. Different groups of rational market participants may have different goals and constraints. These groups create supply and demand for equities. When the equity premium increases, the supply of equities goes down and the demand for equities goes up. The equilibrium equity premium, for which supply matches demand, is in the range of 3%-7%, consistent with the empirical observations.The success of the model in the explanation of the equity market premiums suggests that the survival principle may be used in the economic and financial modeling in parallel with and sometimes instead of the traditional expected utility maximization paradigm. The equity premium diagrams, introduced in this paper, explain the formation of market equity premiums in a clear and simple graphical form.Retirement spending is the main driver of the equity premiums. In 2012, the total US retirement assets of $19.5T exceeded the total equity market capitalization of $18.7T. Retirees are forced to keep assets in low-yield bonds because markets are incomplete: fairly priced truly-inflation-protected annuities are not available for individuals. The ongoing shift to defined contributions will create more demand for bonds and may cause a prolonged financial crisis. Financial institutions and insurance companies can avert it by creating an efficient market of inflation-protected annuities. This may solve the puzzle practically: the equity premiums will shrink together with the puzzle.
Published Version
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