Equity Premium Puzzle - Essay Example

? Equity Premium Puzzle According to Siegel and Thaler (1997, p. 192), equity premium puzzle is the inadequacy of agreeable justification by the economists as to why there is an enormous difference between gains by investments in the governments bonds and those of ordinary stocks. Although people invest their money to obtain gains from the increase in values of the assets, normally unsecured stocks have perceived high gains than the government bonds. The difference in gain between these two categories of investment opportunities is referred to as equity risk premium. Equity premium is meant to cushion stock investors against the risk of losing their investment portfolios (Siegel and Thaler, 1997, p. 195). However, variations in gain between government bonds and stocks are quite vast and yet government bonds also bear some risk especially the risk associated with inflation (Ben-Haim, 2006). People invest their money to benefit from the gain in the value of their assets. However, many people continue to invest in government bonds where there is such small gain than in stock. This has resulted to a dilemma to the economists who have been unable to understand why many people still prefer government bonds despite the huge returns in stocks as compared to bonds (Siegel and Thaler, 1997, p. 192). The investment decision is influenced b perceived risk, investors’ ability to bear risk, investment period, investor satisfaction and utility behaviour. As stated earlier equity premium is the difference in gains between stocks and risk-free assets such as governments’ bond or security bills. The government bonds are believed to bear no risk while ordinary stocks are rated as the most risky venture (Glyn, 2006, p.153). Due to this perception of risk, many people opt to invest their money in government securities where they have guarantee for small gains rather than investing in stocks with prospect for enormous gains but bearing vast risk. Equity premiums are meant to shield investors against enormous threat associated with the perceived loss on investment in the stocks (Siegel and Thaler, 1997, p. 195). This variation is too huge hence economists have never come into consensus as to why people continue to invest in government bonds which normally have low yields compared the stocks. The economists have assumed that investors must have immense risk evading attitude (Ben-Haim, 2006). This is because in the real sense people would invest in stocks which have higher probability for gigantic returns than gains in bonds value. However, since people would want to keep away from risk of any form, they opt to invest in bonds where they have a better chance to gain than in stocks. The economists have also doubted whether stocks truly bear any equity premium, and whether the real gain from the investment reveal value equivalent to the equity premium (Siegel and Thaler, 1997, p. 193). If this is true then what makes investors fail to invest in stocks which bear gigantic equity risk premiums? The investors’ decisions on what type portfolio they should purchase are either influenced by personal factors or market factors (Ben-Haim, 2006). This has also raised concern over the existence of equity premium puzzle. In Siegel and Thaler (1997, p. 193), the dilemma regarding the investor’s decisions could only be a matter of individual taste and preference which cannot be influenced by the market conditions. This difference in gains between risk-free bonds and stocks investments is explained by economists using economic yardstick replica (Siegel and Thaler, 1997, p. 192). To determine this variation economists use “standard equilibrium model” in which the individual’s willingness to utilize resources vary from one period to another, when the risk deterrence attitude remains unaffected The gauge used in this approach is the comparative risk deterrence factor named A. Therefore, the hypothesis was that a decline in utility by 1% should result to an increase in marginal value of the income of the consumer by 1%. Therefore, economists concluded that if the value of coefficient A is between 30 and 40, then the consumers would be required to forgo massive amount of gains in order to keep away from losing value of their investments. The economists termed this unrealistic because in reality, there is no investor who would evade risk to such an extent to forego a chance of making enormous profits from an investment (Siegel and Thaler, 1997, p. 194). Therefore, the perceived vast equity risk premium may not be real otherwise many people would opt to take the chance and invest in the stocks where there is immense expectation for gigantic returns. This is the puzzle which economists could not establish real connection between expected increase in value of the assets and investment decision (Ben-Haim, 2006). The consumer conducts is the most determinant factor rather than the gain in value of the assets. The economists established that if the coefficient is too large, then it depicts that consumers are willing to forgo extremely enormous gains from investments in order to have steady flow of income for longer time (Siegel and Thaler, 1997, p. 195). If stocks have elevated premiums to cushion the investors, then the investors would sacrifice their assets at the present period and buy stocks to spread their income over a long time. The government bonds cushion the investors against market risks and risk due to inflation. It is for this reason that investors opt to invest their funds in the government assets which guarantee small returns in the future rather than investing in the general stocks where the prospect for gigantic loss or vast gains is deeply elevated. This depicts risk deterrence character of the consumers (Camerer, Loewenstein and, Rabin, 2004. P137). Consumers are willing to sacrifice the anticipated gains from stocks due to risk associated with stocks in order to have a guaranteed income in future. Therefore, equity premium offered to cover for the unpredictable loss in the value of invested portfolio is not enough to warrant investors to engage in such risky ventures. This may also mean that consumers are not interested worried current gains but their concern is the unknown potential risks which may occur in the future. The gains on investments are influenced by the period in which the portfolio is invested. Short time investors in government bonds usually realize low gains due to emerging issues such as inflation which were not anticipated during planning for investment. This is because the government does not make short term adjustment for such issues and the investor’s actual gain declines (Camerer, Loewenstein and, Rabin, 2004. P124). On the other hand, the gains from investments in stock vary according to the prevailing market conditions especially in developing countries. In such countries, the actual gains from investments on government bonds are generally low due to political unrest and economic instabilities. The stock investors on the other hand are faced with soaring risk but the investment gains are also elevated to compensate for the chance of losing their investments (Rajnish and Prescott, 1985, p.156). However, investments made over long time and those covering short period does not portray large variations. Regardless of the mount of equity premiums, investors cannot afford to bear such risk due to unknown perils. Therefore, they will desire to invest their funds in government bonds because these are less risky. The source of dilemma occurred when investments in bonds were considered over short time in United States. The result depicted decline in earnings on government bonds hence causing a situation which economists could not comprehend (Glyn, 2006, p.157). This is because, it was expected that the investors could predict the occurrence of economic recession for such a short term investment. On contrary, in the late 1980’s the return on government bond has raised to a promising level. The selection of data from US could have portrayed unclear information and misinterpretation of meaning of equity premium and real investment gain. This is because, during period of 1980’s when this information was being analyzed, US was experiencing tremendous growth in stock value while bonds were on decline due to various economic hardships (Rajnish and Prescott, 1985, p.152). However, the gains on stocks were similarly soaring hence resulting to enormous variation in equity premium. However, other nations which were experiencing growth in value of stocks at the same time yielded different results. For example, Japan and Germany which were undergoing normal economic growth depicted a reduced equity premium (Azeredo, 2007). This is may have resulted to misrepresentation of data since the economists relied on data collected from US and was for a fixed period of time. This may not have been the case had the data been gathered from different parts of the world. Many investors fear investing in stocks due to unforeseen perils. Therefore, investors require high caution on their investments against such unforeseen incidences. As a result, the companies and other stock owners offer high interest gains to the investors as a way of gaining their confidence (Rajnish and Prescott, 1985, p.148). In most cases, these incidences do not occur hence stocks investors end up getting huge gains than those who invest in government bonds (Elroy, Marsh and Staunton, 2006). Therefore, the information which was used to work out for the risk premium variation in gains between government bonds and stocks was based on specific scenarios in US. This information was subjective because it did not take into consideration the investors who had excess capital to risk in stocks. They only considered those who struggled for existence hence could try to avoid risk as much as possible. The value of returns from the investments is altered by the government policies. Government levies tax on gains from the companies’ profits every year (Elroy, Marsh and Staunton, 2006). Therefore, many investors will shun investing in stocks because the tax charges on the companies’ earnings will reduce the gains on the investors’ portfolio. Majority will prefer investing in government bonds which are not subject to annual taxation. This fact may be one of the reasons why people prefer investing in government bonds despites enormous variations in equity premium. The information used in this case did not also include the probability for anticipated peril which never occurred. The anticipated risk at the time of making investment choices affects portfolio selected by the investor (Glyn, 2006, p.159). This should also be considered when working out for the risk premium regardless of whether it really occurred or did not occur. Another phenomenon is caused by effects of hyperinflation and decline in economic value of the economy. In case of hyperinflation, the value of assets generally escalates abnormally resulting to decline in gains on stock for the investors (Siegel and Thaler, 1997, p. 196). Consequently, the value investments on bonds escalate hence high returns for the bond investors. Therefore, during period of hyperinflation, the equity premium risk gap reduces. On the other hand, the declines in value of the economic wealth results to declines in bond investors’ gains, while the gain on stocks goes up. This widens the equity premium gap. These scenarios result to equity premium puzzle. The duration of investment influence the gains obtained from ether stocks or bonds. When investment is made on government bonds for a long time, the average annual return tends to be lower than gains from the same amount invested in government bonds over a short period of time (Azeredo, 2007). On the other hand, investment made on stocks over a shorter period tends yields higher returns than those invested over a long time. This is because, investments made for long time results to neutralization effects. Those years with large gains cancel with the years which had small returns. Therefore, since the average annual returns from both investments is worked out using standard deviation, the results will depicts that long investment periods haves smaller gains than shorter investment period (Siegel and Thaler, 1997, p. 197). This means that equity premium should be declining. Therefore, the fact is that long term investment on government bonds is riskier than stock if both scenarios were considered over long term. This has been another reason why equity premium has remained a puzzle to the economists. Investors prefer spreading their risk over long period of time. They fear losing their income in the short run than they would in the long run. Therefore, many investors will prefer investing in government bonds which have long maturity period instead of investing in stocks which have characteristic short period gains (Siegel and Thaler, 1997, p. 197). This is an indication that investors evade risk in the short run but will prefer to take risk if it perceived to occur after long time. Consumers have tendency for keeping their investments in form which is not prone to misuse (Glyn, 2006, p.146). Investments on stock are available for use within a shorter duration than assets held in government bonds. Therefore, investors prefer to invest in bonds even if their return is lower than that of stock. Investing in stock could result to unnecessary misuse hence distorting the real intention of investment. Investor contentment is achieved in comparison of their status to that of others. This means that an investors will more contented if they perceive that after doing something they will be in a better position than others after utilizing the same commodity (Ben-Haim, 2006). They will be compelled to do things which they believe will put them in a better position than others. Therefore, investors will opt to invest in long term bonds hence taking risk for future investments rather than for short term (Siegel and Thaler, 1997, p. 199). It is for this reason than many people prefer investing in government bonds instead of investing in stocks with potential for higher gains. Investors satisfaction is driven from alterations of the in the worth of their investment assets. The fact is that investors are offended by decline in their wealth much more than the contentment they get from increase in value of their assets (Shlomo and Thaler, 1995, p.75). This also affected by the period in which gains or losses will be attained. Risk evaders investors will prefer investing their resources in bonds because their value alters after a long period. However, the value of stocks keeps on altering up and down every day (Shlomo and Thaler, 1995, p.76). Therefore, investing in stock value will psychologically impact the investor negatively much more than the satisfaction their will derive from an equivalent daily gain in the same stock asset. In a free economy, individuals strive to reap maximum benefit at the expense of others. As a result, the cost of individual investment decision is bound to rise. This is because actions taken by other people may be detrimental to the society, hence forcing others to pay high cost to correct the crime of others (Ben-Haim, 2006). Also, there is high transaction cost associated with market activities. In such a circumstance, individuals will prefer investing in government bonds which are more open to the public than stocks. Investing in stocks may result to undisclosed cost to the investors. This is because the individual investors may not be familiar with the nature of company’s industry, although his is a critical factor to consider when making an investment decision. Also, some company’s fail to disclose some vital secretes of the company which may affect its performance in future. Such information may be that which relates to retirement of senior manager. If the company fails to get another competent manager, its performance may decline resulting to decline in its assets value (Siegel and Thaler, 1997, p. 199). Government bonds are not prone The choice of buying either stocks or bonds is influenced by a number of aspects. The ability to tolerate risk is the major cause of selecting between purchasing stocks and government securities (Siegel and Thaler, 1997, p. 195). Stocks bear equity premium to influence people to purchase stocks over bonds. However, equity premiums have repercussions (Moskowitz and Vissing-Jorgensen, 2002). During the period of recession, equity premium results to price increases in the value of companies cost in terms of investors returns. Since the companies have to pay corporate tax to the government from the profit they make, this results to companies’ huge loss in form of corporate tax they pay to the government. Companies are compelled to make regulations to influence the investor’s decisions regarding the investment in their companies. Equity premiums generally enable investors to make their decisions regarding the portfolio choices the investors will purchase. Investors may decide to buy stocks if they anticipate huge gains from the stock assets. The companies have to set their regulatory framework to guide the decision of setting the equity premium aimed at influencing investors’ decisions in the purchase of stocks. Despite vast risks and returns associated with stock portfolios, many investors prefer buying government bonds which have characteristic low risk and low returns (Siegel and Thaler, 1997, p. 194). The huge difference in equity returns between these two investments portfolios. This has resulted to lack of conclusion by economists on what really affects investors’ decisions. The puzzle is due to the fact that most investors still prefer government bonds to stocks. Investors prefer spreading their risks over a long time. They invest in government bonds which usually mature over long time (Ben-Haim, 2006). Consumers derive their utility in relation to what other consumers have achieved. They prefer investing in bonds to gain status in the future. When stocks and bonds are invested over a long period of time they are likely to yield similar returns. Bonds also portray higher risks if invested over a long period. This means that bonds are not as secure as many people tend to believe. The only difference is the period of investment. Bibliography Azeredo, F. 2007. "The Equity Premium: A Deeper Puzzle", University of California at Santa Barbara, Economics Working Paper Series. Ben-Haim, Y., 2006. Info-Gap Decision Theory: Decisions under Severe Uncertainty, Academic Press, 2nd edition. Camerer, C.F., Loewenstein, G. and, Rabin M. 2004. Advances in Behavioral Economics. Princeton, NJ, Princeton University Press. Pp. 767 Elroy, D., Marsh, P. and Staunton, M. 2006. "The Worldwide Equity Premium: A Smaller Puzzle". London Business School. Glyn, A. 2006. Capitalism Unleashed: Finance Globalization and Welfare. New York, Oxford University Press. PP.251 Moskowitz, T. J. and Vissing-Jorgensen, A. 2002. The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle? NBER Working Paper No. 8876 Rajnish, M. and Prescott, E. C. 1985. "The Equity Premium: A Puzzle" Journal of Monetary Economics vol.15 (2): 145–161 Shlomo, B. and Thaler, R. H. 1995. "Myopic Loss Aversion and the Equity Premium Puzzle". The Quarterly Journal of Economics, vol. 110 (1): The MIT Press. Pp. 73–92. Siegel, J.J. and Thaler, R.H (1997. Anomalies: The Equity Premium Puzzle; The Journal of Economic Perspectives, Vol. 11, No. 1. pp. 191-200. Read More