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The Equity Premium Puzzle- A Model for Its Behavior

The Equity Premium Puzzle- A Model for Its Behavior

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Published by: Journal of Undergraduate Research on Jul 08, 2009
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ECONOMICS
The Equity Premium Puzzle: A Model forIts Behavior
Timothy P. Lavelle
I
n the United States, there exist independent markets for risk free government bond securitiesand risky equity securities. A rational/sophisticated investor will build a portfolio out of thesetwo components in such a way as to optimize his portfolio in terms of the ratio of riskiness (or,more specifically, idiosyncratic variability) and expected return (Black and Litterman 1992).Once this equilibrium condition is met (an investor-specific optimal allocation between risky andrisk free securities) the rules of arbitrage pricing should keep the return spread between these twosecurities at an equilibrium level (Brennan, Schwartz and Lagnado 1997). From this notion of anarbitrage pricing model, one can look at historical returns in the United States and appreciate thatthe aggregate return spread between the market index for equity securities and government debtinstruments should be characterized by a function of expected returns, risk, and investor  preference for risk. This premium has been roughly 6% over the long run (Kocherlakota 1996).Given the observed level of risk for each asset class, one can then derive the implied risk  preference profile of the investing community in aggregate. This stream of analysis has beenapplied to what has come to be known as the equity premium puzzle. While the fact that a premium exists is not a puzzle to even the most naïve of market observers, it is the magnitude of this premium that is interesting and perplexing. No theory to date has been able to explain itfully, and thus, the focus of this article will be to demystify its enigmatic behavior using adynamical systems approach.As stated previously, the premium return of equity securities over government debtsecurities is inevitable due to the greater systematic and idiosyncratic risk of equity returns in themarket. The problem, however, is determining whether this premium is appropriate given thelevel of risk and investors’ risk aversion, or if it is, in fact, extreme. Siegel and Thaler use autility preference model to describe the level of risk aversion implied by the long run 6% equity premium (Siegel and Thaler 1997). The following anecdote demonstrates this level of risk aversion. Given a fair bet with 50% probability of winning and exactly doubling one’s entirewealth and a 50% probability of losing and exactly halving one’s entire wealth, an individualwith the implied level of risk aversion derived from the equity premium would be willing to pay49% of his or her entire wealth to avoid the gamble (Siegel and Thaler 1997). Thus, if one haswealth of one million dollars and is given a 50% chance to either be worth two million dollars or 500 thousand dollars, that individual would rather pay 490 thousand dollars to avoid this bet.This person would rather sacrifice 490 thousand dollars with 100% certainty than have a 50%
 
chance of winning more money and a 50% chance of losing only ten thousand dollars more.While there is no way to prove mathematically that this implies the equity premium isimplausible and ludicrous, one can see from this demonstration that it is self-evident. It would bedifficult, if not impossible, to find an individual who would behave under these conditions in asimilar manner. Thus, if it is hard to find one person, it is certainly impossible to assume that theaverage market participant would behave such as this.From this brief (and relatively rough) anecdote, one can innately see that the equity risk  premium is too large to be described using a simple rational investor model. In fact, Mehra andPrescott resolve that the only way to explain or make sense of the equity premium is if thetypical investor is implausibly, and thus unnaturally, averse to risk (Mehra and Prescott 1985).As a result, many economists have attempted to explain and describe the causes of this premium, but as of yet, none have fully succeeded (Kocherlakota 1996). Accordingly, the question of thisstudy is not what accounts for the equity risk premium, or even why it is so large. Rather, thisstudy will attempt to describe the dynamic nature of its level through time.Ever since the advent of Modern Portfolio Theory, it has been widely accepted that the best way to examine an investment in a financial security is not to analyze its historical returnsand deviations, but rather to make estimates of the future behavior of these securities (Fabozzi,Gupta, and Markowitz 2002). That being said, often the best proxy for the future is the performance of the past. Many of the attempts at describing the equity premium puzzle haveconcentrated on predicting the future level of the premium based on forecasted future levels of consumption, return, and risk aversion (Kocherlakota 1996). In contrast, this study will attemptto explain the oscillations of the equity premium as an entity in and of itself rather than as aspread between two unrelated (or related) securities. The central hypothesis of this study is thatthe equity premium has a mean, which is non-stationary as a result of market shocks, and behaves in a constant, predictable manner around that mean after accounting for noise.
Method
Subjects.
The subjects used in this analysis are the New York Stock Exchange (NYSE)aggregate index and the 90-day U.S. Treasury bill. The NYSE aggregate index was selected as a broad market index to track the general movement of the U.S. security prices for an extended period of time. This index has been available for over 100 years and has always represented awide range of diversified industries present and operating within the United States. Unlike someother market indices, it has exhibited somewhat more damped market cyclicality as a result of its broad industry base. The constituents of the index include all equity securities actively traded onthe New York Stock Exchange as of the date of each data measurement. Therefore, asurvivorship bias is not introduced and thus the index is constantly evolving. The value-weightedversion of this market index was chosen so that securities that are larger on the market are thuslarger within the market index and the opposite for small securities.The 90-day U.S. Treasury bill was selected as the representative risk-free rate for severalreasons. Since it is a U.S. Treasury debt instrument, it is backed by the full faith and trust of theUnited States Government. In the financial community, this is seen as the equivalent of defaultrisk-free. Given that this is a fixed maturity, zero coupon 90-day bill, inflation risk is virtuallynonexistent as well. For the purposes of this study, it is assumed that U.S. inflation was relativelyconstant for any 90-day period over the last 100 years. For the few time periods that may haveexhibited more turbulent inflation, it is assumed that these effects are damped in the analysis by a
 
corresponding effect on the equity index levels observed. While using a shorter maturity billwould reduce the inflation risk just slightly more, the more volatile nature of these securitiesoutweighs the risk-reduction benefit and may in fact add unwanted noise to the analysis.
 Apparatus.
The apparatus used to collect the price information for the study’s time period(1934 to 2004) for each security is the Center for Research in Security Prices (CRSP). The CRSPis operated and maintained by the University of Chicago Graduate School of Business and iswidely considered the industry standard in historical security prices. The data was downloadedon October 2, 2005 and should be considered current and accurate as of the most recent CRSPupdates to that point. The data will be analyzed using R statistical software in an effort to isolatethe non-stationary mean and fit the resulting trends to an appropriate model.
 Procedure.
For each security, the monthly nominal price levels from 1934 to 2004 wereused to calculate monthly nominal returns. Monthly data points were used as they provide manydata points while also not introducing an undue level of noise to the analysis from weekly or daily returns. The period 1934 to 2004 is used as it is the longest period available for which bothsecurities have a complete data set on record in the CRSP database. Once the monthly returns arecalculated, the risk free return is subtracted from the equity return to calculate the equity risk  premium. A plot of this time series is available in appendix A.
Results
 Descriptive statistics.
Given that this data set represents a time series of returns, the mostappealing measure of central tendency is the geometric average return. This return (GAR) iscalculated as follows (1):Where
n
is equivalent to the number of discrete periods (852 months) and
is equivalentto the period return. Thus, for this time series, the resultant geometric average return is 0.57% per month. In order to get an annual estimation of the equity premium, the rate can becompounded for 12 months (2):Consequently, the annual geometric average equity risk premium from 1934 to 2004 is7.10% (SD = 4.49%). This is consistent with Mehra and Prescott’s calculation of the market risk  premium as 6.90% (notice the discrepancy as a result of calculations based on different years).Given that this is a time series that incorporates regular compounding, the geometricaverage return is the most accurate and appropriate measure of central tendency. Though, for thesake of comparison, the arithmetic monthly return annualized is 8.41% and the median monthlyreturn annualized is 11.90%. Thus, the geometric return is a considerably more conservativedescription of the central tendency of the time series than either the arithmetic average or median.In order to determine whether this time series phenomenon can be described as a series of overlapping sinusoidal waves, a Fourier analysis was completed. This Fourier analysis should beable to indicate whether there is some sort of a recurring cycle underneath the string of seemingly white noise. In order to perform the analysis, the Fast Fourier Transform function in

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