The equity premium

Abstract

This chapter explains ‘the equity premium puzzle’ and ‘the risk-free rate puzzle’. The chapter starts out comparing historical returns on stocks to historical returns on bonds, as well as the risks associated with these returns. The standard models economists use to explain the relative sizes of stock and bond returns, and hence the equity risk premium, are based on the exposure of stocks and bonds to economic growth. The chapter explains why these standard theories fail to explain the size of the equity premium. The chapter also explains how economists have changed their workhorse models to reconcile why returns on stocks are so high compared to bond returns. Another key insight in the chapter is that the equity premium does not depend linearly on economic growth in itself, but on the volatility of economic growth and its correlation with stock returns. Two countries can experience the same level of average economic growth, but different volatilities of consumption growth and correlations between consumption growth and stock returns, causing stock returns to differ between countries. This is one more reason why Chapter 6 finds that economic growth does not line up with stock returns across countries.