Question

What is the equity premium puzzle? And what are two explanations that “resolve” the puzzle?

Answer 1

The equity premium puzzle is a very much researched topic which explores the inconsistency in financial economic theory.Basically, the puzzle revolves around the historic long run differential in returns between equities and treasury bonds.

The basic principle in financial theory provides that the long term returns of any two assets class should converge. In the short-term, the potential return of each individual investment is assumed, in most circumstances, to be proportional to the amount of risk it holds. While some riskier investments could pay off better than less risky investments, the expected return of each investment must be equivalent. Otherwise investors could expect to earn more by investing in certain assets over others.

The two explanations that can resolve the puzzle are Statistical error in the equity premium finding and the other can be the difference in volatility risk.