The Equity Premium Puzzle: High Required Premium, Undervaluation and Self Fulfilling Prophecy

Abstract

Mehra and Prescott (1985) argued that, according to sensible asset pricing models, stocks should provide at most a 0.35% premium over bills. However, companies use higher equity premia (average around 6%) for evaluating their investment projects, professors use in class and in their textbooks higher equity premia (average around 6%, range from 3 to 10%) and investors use higher equity premia for valuing companies. The overall result is that equity prices are, on average, undervalued (and have been undervalued in the last decades) and, consequently, the measured ex-post equity premium (HEP) is also high. If the additional returns beyond the risk-free rate demanded by equity investors (ex-ante risk premia) and used in financial asset pricing models have been high, it is not a surprise that the ex-post risk premia (calculated with historical data) have been also high. If most investors use historical data to estimate the required and the expected equity premium, the undervaluation and the high ex-post risk premium are self fulfilling prophecies.