The equity premium puzzle refers to the phenomenon where real returns on equity are much higher than government bonds, and experts disagree on whether it is a true mystery or a normal market response. The puzzle may be caused by factors such as investor perceptions or flawed risk aversion models, but there is no universal explanation.
The equity premium puzzle is a situation in which the real returns on equity issues are substantially higher than the returns on government bonds. One of the confusing aspects of the puzzle is that some financial experts claim that the puzzle doesn’t really exist at all, while others see this as a true phenomenon but disagree on the reasons for this type of activity. As such, the equity premium puzzle represents something of an ongoing mystery that is not likely to be solved in the near future.
For those who view the equity premium puzzle as a mystery, the process begins by defining what constitutes an equity premium that is well above average. This starts with understanding that an equity premium is the return on equity minus the amount of bond yield generated within a specified period of time. The difference is usually expressed as a percentage. In the United States, this percentage is normally set at 6%, although some analysts believe that this figure is too high.
Financial experts who deny the existence of an equity premium conundrum are not denying that there are periods when the difference between stock returns and government bond yields fluctuate, sometimes at unusually high levels. What they do deny is that there is any real mystery at all. Those who approach capital premium fluctuations in this way view activity as normal responses to events that occur in the market from time to time. From this perspective, the activity is to be expected and does not constitute anything that should be considered out of the ordinary.
Regardless of one’s stance on whether or not this fluctuation is a mystery, there are several theories as to what can lead to situations that some choose to call an equity premium puzzle. Among these are factors that affect the expected return on bonds or investments. This may include investor perceptions of the potential impact of political issues, new technology, or consumer demand on certain key types of investment. Others believe that a possible source of the puzzle is the fact that a risk aversion model that is currently considered standard is flawed and must be adjusted to accommodate current data. At present, there is no universal set of explanations for why an equity premium puzzle might exist, even if there is no universal agreement on whether the puzzle is a real phenomenon or just an artificial construct derived from the arrangement of statistics. .
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