Summary of the Equity Premium Puzzle
The equity premium puzzle is the phenomenon that equity returns are consistently higher than the expected return predicted by the CAPM Model. This excess return is the equity premium, which is the difference between the expected return and the actual return of the equity markets. The puzzle surrounding this is why the equity premium is so high when the CAPM Model predicts a much lower return.
Empirical Evidence of the Equity Premium Puzzle
The equity premium puzzle has been studied for decades and empirical evidence suggests that the equity premium is higher than predicted by the CAPM Model. One of the earliest studies was from Fama and French in 1992, which showed that the equity premium was 5.5% higher than the CAPM expected return. Since then, other studies have found similar results.
Possible Explanations for the Equity Premium Puzzle
Several theories have been proposed to explain the equity premium puzzle, such as the risk-free rate theory, the risk aversion theory, and the liquidity preference theory. The risk-free rate theory suggests that the equity premium is due to the fact that the risk-free rate is lower than the expected rate of return. The risk aversion theory suggests that investors are risk-averse and therefore prefer to invest in equities rather than bonds. Finally, the liquidity preference theory suggests that investors may prefer to invest in liquid assets, such as equities, rather than illiquid assets, such as bonds.
Implications of the Equity Premium Puzzle
The equity premium puzzle has several implications for investors. First, it suggests that investors should be aware of the potential for higher returns when investing in equities. Second, it suggests that investors should be aware of the risks associated with investing in equities, as they may be higher than expected. Finally, it suggests that investors should carefully consider their risk preferences when making investment decisions.
Related Questions
- What is the CAPM Model?
- What is the equity premium?
- What are the possible explanations for the equity premium puzzle?
- What are the implications of the equity premium puzzle?
- What is the difference between risk-free rate and expected return?
- What is the risk aversion theory?
- What is the liquidity preference theory?
- What is the evidence of the equity premium puzzle?
- What are the risks associated with investing in equities?
- How should investors consider their risk preferences when investing?