Understanding the Equity Premium Puzzle
George M. Constantinides, Leo Melamed Professor of Finance, University of Chicago
Professor Constantinides held a BP Visiting Professor Lecture on March 13 2007 entitled 'Understanding the Equity Premium Puzzle'. The main topic of the lecture was to understand what the equity premium puzzle is, why economists and investors should care to find rational explanations to it and to review some proposed approaches to resolve the puzzle.
Professor Constantinides started by defining the equity premium as the difference between equity returns and the interest rate. He showed that the average equity premium has been positive in many countries. For instance, the realized U.S. equity premium in the 1926 - 2004 period is 7.30% per annum. This does not seem to be a one-off event as the expected equity premia have also been large. For example, the long-term expected premium in the U.S for the 1926 - 2004 period is 6.23% per annum. These figures are to some extent in line with conventional wisdom: the higher the risk, the higher the return demanded by investors. The puzzle emerges in that standard economic models cannot rationalize such levels of equity risk premium. The standard economic models also fail to explain related economic puzzles: the interest rates are too low, the variance of stocks are too high, the variance of interest rate is too low, and returns are too predictable.
It was argued that investors should care about finding a rational explanation for this phenomena since it is impossible to make forecasts on irrational markets. Moreover, economists should also care to find rational explanations because if it is not possible to explain the basic equity premium puzzle, then economists cannot hope to explain other puzzles such as value versus growth stock premium, small versus large stock premium, recent winning versus losing stock premium, and long-term versus short-term bond premium.
The speaker reviewed three main approaches proposed in the literature to address this puzzle. The first approach is to incorporate job loss in current economic models. Job loss is an uninsurable event that is countercyclical and that has persistent implications. Saving by investing in equity is not a useful hedge against job loss since, in recessions, equity loss and job losses are highly correlated. Therefore, investors demand a high risk premium to hold equity.
The second approach is to consider borrowing constraints. Given the large observed equity premium, young investors would like to invest in equity. However, they are unable to participate in the stock market because most of their income is coming in the future. Furthermore, it is very difficult to borrow against future income to invest in stocks. Middle-age investors save by investing in the stock market. Old-age investors dis-save in order to consume. This concentration of risk generates high risk premia.
The third approach is to introduce habit persistence in economic models. In a recession, returns and consumption are low and marginal utility is high. In standard models, this is not enough to generate the observed levels of equity premium. In the presence of habit persistence, utility from current consumption depends on how high current consumption is relative to past consumption. Therefore, in a recession, a decrease in consumption increases the habit-to-consumption ratio and thus risk aversion. This high risk aversion generates the high observed premium.
Professor Constantinides concluded that the equity premium puzzle can be rationalized by extending the standard economic model. He also mentioned that there are other explanations to this puzzle and that more work needs to be done. Professor Constantinides reiterated the importance of finding rational explanations to the equity premium puzzle and stressed the fact that rational economic and financial theory is a flexible and useful tool in understanding asset prices, making economic predictions and guiding economic policy.
George Constantinides (Leo Melamed Professor of Finance at the University of Chicago's Graduate School of Business) gave a BP Visiting Professor Lecture on 13 March 2007 on the topic of "Understanding the Equity Premium Puzzle".
Professor Constantinides is one of the most prominent and creative research scholars in the field of financial economics, in particular of theories of asset and derivatives pricing. He is former president of the American Finance Association, former president of the Society for Financial Studies and a member of Dimensional's boards of directors of its US mutual funds.
George has written highly regarded papers on the impact of investor preferences, and on the effect of restricted market participation on equity returns. These papers have been extremely influential in addressing the so-called 'equity premium puzzle' of risk-premia in stock returns that appear to be out of line with the variability of aggregate consumption in major economies, for 'reasonable' levels of investors' risk-aversion.