The equity premium puzzle (EPP) is a term coined by economists Rajnish Mehra and Edward

Prescott in a seminal 1985 paper. The puzzle refers to the empirically observed phenomenon that
stocks have consistently offered a much higher average

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The equity premium, in this context, refers to the difference in returns between equities (stocks)
and risk-free government bonds. Historically, in markets such as the United States, the average
annual return on stocks has been about 6% to 8% higher than the return on bonds. Traditional
economic models, which assume rational investors and efficient markets, struggle to justify such
a large differential based on risk aversion levels alone. According to these models, for the
observed equity premium to be rational, investors would have to be implausibly risk-averse.

Theoretical Explanations for EPP

1. Consumption-Based Models:
These models link the equity premium to consumption risk. The basic idea is that stocks are
riskier because their returns are more correlated with changes in consumption; during economic
downturns, when the utility of wealth is higher (as money is tighter), stock returns tend to be
lower. However, these models often require unrealistically high levels of risk aversion to match
the historical equity premium.

2. Habit Formation Models:

These models suggest that people's utility depends not just on absolute consumption, but also on
their past consumption habits. If people get used to a certain level of consumption, significant
drops from this level (which are more likely in bad economic times correlated with poor stock
returns) are particularly painful. This could potentially explain a higher risk premium for stocks.

3. Long-Run Risk Models:

Proposed by researchers like Ravi Bansal and Amir Yaron, these models introduce time-varying
expected returns and economic uncertainty (or "long-run risk") that affects both expected growth
rates and the discount rates investors use. These models attempt to align better with observed
risk premiums by introducing more realistic dynamics in economic growth expectations.

4. Rare Disasters Models:

Economist Robert Barro suggested that rare but extreme events (like depressions or major wars)
could lead investors to demand a higher risk premium on stocks due to the small probability of
catastrophic losses. These models can generate a high equity premium if the perceived risk of
disasters is high enough.

Behavioral Explanations and Experimental Evidence

Behavioral finance offers an alternative viewpoint by suggesting that the decisions of investors
are not always rational or utility-maximizing in the classical sense. Several behavioral factors may
contribute to the equity premium puzzle:

1. Loss Aversion:
Investors might be particularly sensitive to losses relative to gains. This can lead to an
overestimation of the risk associated with stocks, prompting a demand for higher returns as
compensation for perceived risks.

2. Myopia and Mental Accounting:

Investors might focus too heavily on short-term volatility and losses, leading to an aversion to
stocks despite their favorable long-term returns.

3. Over-extrapolation of Past Returns:

Investors might irrationally extrapolate past poor stock returns well into the future, increasing
their perception of stock market riskiness.

Experimental evidence often supports these behavioral theories. Laboratory experiments and
surveys have shown that individuals often make choices that deviate from the predictions of
classical economic models due to psychological biases and heuristics. For example, experiments
involving simulated investment decisions have demonstrated that individuals display significant
loss aversion and are influenced by the framing of investment outcomes.

In conclusion, while traditional models based on rational economic actors struggle to fully explain
the EPP, behavioral finance provides a compelling framework that aligns closely with empirical
and experimental observations. The behavioral approach suggests that psychological factors and
cognitive biases play crucial roles in shaping investment decisions and market outcomes, offering
a more nuanced explanation of the equity premium puzzle.