<p><a href="http://www.sciencedirect.com/science/article/pii/0304393285900613" rel="nofollow">The equity premium: A puzzle</a> (Mehra and Prescott (1985)) lays out the basic problem with equity returns:</p>

<blockquote>
  <p><strong>Restrictions that a class of general equilibrium models place upon the
  average returns of equity and Treasury bills are found to be strongly
  violated by the U.S. data in the 1889–1978 period.</strong> This result is
  robust to model specification and measurement problems. We conclude
  that, most likely, an equilibrium model which is not an Arrow-Debreu
  economy will be the one that simultaneously rationalizes both
  historically observed large average equity return and the small
  average risk-free return.
  ...Historically the average return on equity has far exceeded the
  average return on short-term virtually default-free debt. Over the
  ninety-year period 1889-1978 the average real annual yield on the
  Standard and Poor 500 Index was seven percent, while the average yield
  on short-term debt was less than one percent. The question addressed
  in this paper is whether this large differential in average yields can
  be accounted for by models that abstract from transactions costs,
  liquidity constraints and other frictions absent in the Ar~ow-Debreu
  set-up. Our finding is that it cannot be, at least not for the class
  of economies considered. Our conclusion is that most likely some
  equilibrium model with a friction will be the one that successfully accounts for the 
  large average equity premium.</p>
</blockquote>

<p>I've summarized this for my grandmother by saying that the most basic economic models explain the high equity premium by saying people are very risk adverse but if they are that risk adverse, other things make no sense, like how much people charge to do dangerous jobs.</p>

<p>In the 30 years since, much ink has been spilled on the subject of just what is causing the equity premiums in the historical record. Indeed, there is a huge book, the 
 <a href="http://www.sciencedirect.com/science/book/9780444508997" rel="nofollow">Handbook of the Equity Risk Premium</a> that just summarizes these results. I've read much of this book and I've come away a bit confused. There are so many explanations each capable of explaining much of the puzzle that the puzzle itself appears overdetermined. That is, if all the (or even several popular ) explanations are true, the question isn't <strong>"why is the premium is so large?"</strong> but rather <strong>"why is the premium so small?"</strong>. </p>

<p>What are we to conclude about this? All the explanations jointly can't be true, some are contradictory. For example, <a href="http://faculty.chicagobooth.edu/pietro.veronesi/research/peso3.pdf" rel="nofollow">the peso and reverse-peso explanation</a> says long run returns are likely lower than historical returns in the USA, while <a href="https://www.academicwebpages.com/preview/mehra/pdf/Ch02-N50899.pdf" rel="nofollow">preference based explanations of the equity premium</a> need an actual premium to explain. However, once we've eliminated the contradictory explanations, what then? What does one conclude about the individual explanations, the literature as a whole, and the underlying phenomenon?</p>

CC BY-SA 4.0
2022-04-18T20:00:52.180Z
Maybe that's true.
Econ
CC BY-SA 3.0
2015-02-10T04:17:16.197Z
I think the thing is that none of these explanations is perfect. Each has its own problematic oddities that make them insufficient. As an example, consider this response to an external habit model: http://www.nber.org/papers/w14772. Uhlig and Ljungqvist  "calculate that a society of agents with the preferences and endowment process of Campbell and Cochrane (1999) would experience a welfare gain equivalent to a permanent increase of nearly 16% in consumption, if the government enforced one month of fasting per year, reducing consumption by 10 percent then."
jmbejara
<finance><risk>
What can we conclude from the overdetermined equity premium puzzle?
BKay
# What can we conclude from the overdetermined equity premium puzzle?

(Asked by: username_0 on 2015-02-09)

[The equity premium: A puzzle](http://www.sciencedirect.com/science/article/pii/0304393285900613) (Mehra and Prescott (1985)) lays out the basic problem with equity returns:

> **Restrictions that a class of general equilibrium models place upon the
> average returns of equity and Treasury bills are found to be strongly
> violated by the U.S. data in the 1889–1978 period.** This result is
> robust to model specification and measurement problems. We conclude
> that, most likely, an equilibrium model which is not an Arrow-Debreu
> economy will be the one that simultaneously rationalizes both
> historically observed large average equity return and the small
> average risk-free return.
> ...Historically the average return on equity has far exceeded the
> average return on short-term virtually default-free debt. Over the
> ninety-year period 1889-1978 the average real annual yield on the
> Standard and Poor 500 Index was seven percent, while the average yield
> on short-term debt was less than one percent. The question addressed
> in this paper is whether this large differential in average yields can
> be accounted for by models that abstract from transactions costs,
> liquidity constraints and other frictions absent in the Ar~ow-Debreu
> set-up. Our finding is that it cannot be, at least not for the class
> of economies considered. Our conclusion is that most likely some
> equilibrium model with a friction will be the one that successfully accounts for the
> large average equity premium.

I've summarized this for my grandmother by saying that the most basic economic models explain the high equity premium by saying people are very risk adverse but if they are that risk adverse, other things make no sense, like how much people charge to do dangerous jobs.

In the 30 years since, much ink has been spilled on the subject of just what is causing the equity premiums in the historical record. Indeed, there is a huge book, the
[Handbook of the Equity Risk Premium](http://www.sciencedirect.com/science/book/9780444508997) that just summarizes these results. I've read much of this book and I've come away a bit confused. There are so many explanations each capable of explaining much of the puzzle that the puzzle itself appears overdetermined. That is, if all the (or even several popular ) explanations are true, the question isn't **"why is the premium is so large?"** but rather **"why is the premium so small?"**.

What are we to conclude about this? All the explanations jointly can't be true, some are contradictory. For example, [the peso and reverse-peso explanation](http://faculty.chicagobooth.edu/pietro.veronesi/research/peso3.pdf) says long run returns are likely lower than historical returns in the USA, while [preference based explanations of the equity premium](https://www.academicwebpages.com/preview/mehra/pdf/Ch02-N50899.pdf) need an actual premium to explain. However, once we've eliminated the contradictory explanations, what then? What does one conclude about the individual explanations, the literature as a whole, and the underlying phenomenon?

**Tags:** finance, risk

> **Comments:**
> **username_2**: I think the thing is that none of these explanations is perfect. Each has its own problematic oddities that make them insufficient. As an example, consider this response to an external habit model: http://www.nber.org/papers/w14772. Uhlig and Ljungqvist  "calculate that a society of agents with the preferences and endowment process of Campbell and Cochrane (1999) would experience a welfare gain equivalent to a permanent increase of nearly 16% in consumption, if the government enforced one month of fasting per year, reducing consumption by 10 percent then."  
> **username_1**: Maybe that's true.  

---

## 0 answers

