The Phenomenon of the Equity Premium Puzzle - Assignment Example

The Equity Premium Puzzle, And Empirical Approaches to Explain the Phenomenon Introduction:- Equity premium is a term describing the gap between return on equity/stocks and return on default free debt instruments or government bonds, in other words it can also be said the reward of taking risk. While according to Investopedia equity premium puzzle is “A phenomenon that describes the anomalously higher historical real returns of stocks over government bonds”[www.investopedia.com/terms/e/epp.asp#ixzz2Guhq8Cg1] The term was first introduced and officially announced by Rajnish Mehra and Edward C. Prescott in 1985 in their Journal “The Equity Premium, A Puzzle”. In their research they note that during the 90 years period (1889-1978) average return on equity was about 7% while during the same period average yield on short term debt instruments or average risk free rate was less than one percent, which leads to an average equity risk premium of more than 6% [MEHRA & PRESCOTT,1985] which means that investors are immensely and unexplainably high risk averse if they choose to invest in bonds instead of stocks, despite of such a high return provided by equity. Such an unusual situation may be caused by two factors either the risk premium is too high to be unexplainable or risk free rate is too low. “An additional puzzle – the risk-free rate puzzle - emerges instead: why is the risk-free rate so low if agents are so averse to Inter-temporal substitution?” [WEIL.1989] Historically numerous attempts have been made by economist, financial analysts and researchers to explain the phenomenon of the equity premium puzzle using different assumptions, theorems and alternative models. A few empirical approaches are discussed below. Behavioral Explanations:- Behavioral finance provides a very useful insight on how human behaviors can affect investment decisions and result. Its example is that individuals are highly risk averse, they get more pain from shocks as compared to the pleasure they get from profit/benefit. Moreover on average odds of 2:1 or greater are required for their acceptance of an even money (50:50) bet. Myopic Loss Aversion:- Myopic loss aversion is a behavioral finance approach used to explain the size of equity risk premium. Behavioral finance deviates from the standard economic theory and integrates the human psychology with economic theory. Concept of myopic loss aversion rests on two principals 1. Loss aversion and 2. Mental accounting. Concept of loss aversion implies that investors are more sensitive to losses as compared to profits. “Mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities” [THALER.1999] It includes the cognitive and unconscious operations used by people to organize, evaluate and keep track of financial activities. This approach implies that people tend to make and evaluate decisions one at a time and then they place them in separate mental accounts rather than evaluate them in a broader context. In a financial perspective, this refers to how transactions are grouped both cross-sectionally (are securities evaluated one at a time or as portfolios) and inter-temporally (how often are portfolios evaluated). When this narrow evaluation of the decisions and outcomes take place, financial investors will tend to make short-term decisions rather than adopt long-term policies regarding their investments and evaluate their gains and losses frequently [THALER, TVERSKY, KAHNEMAN & SCHWARTZ 1997] “When we look at the historical record of investment returns, we find that the vast majority of long-term returns are derived from just seven percent of all trading months. The returns of the remaining ninety-three percent of the months on average is virtually zero” [SWEDROE 2002] It implies that the shorter the investment horizon, greater the chances that the investor will experience a loss in the value his portfolio. Moreover if an investor has the risk averse preferences then the time horizon over which he evaluates his portfolio also impacts his investment preferences. For example stocks seems to be risky and yield less returns in the short run, while debt instrument are more safe and seem to be profitable in short run. So if a risk inverse investor inspects his portfolio daily then he will find the bonds much more profitable and attractive as compared to stocks and will find the stock highly risky and yielding lower returns, because stock prices highly fluctuate up and down on daily basis and losses have a double effect on investor’s mind. As compared to it a less risk inverse and more informed writer knows this behavior of stocks and knows that at end they always have been profitable, and knows that the risk associated with the volatility of the stock will be automatically diversified by increasing the investment horizon. So this assumption implies that if people will focus on short term returns they will more likely invest in bond/debt instruments but if investors will focus on long horizon then they will tend to invest in stocks. Historical Attempts to explain the phenomenon:- Since yet analysts, economists and researchers have made several attempts to resolve this phenomenon, but generally lies a consensus over the integrity and soundness of the model. Complete market Assumption:- Complete market assumption is used by Mehra and Prescott in their model to explain the phenomenon. This assumption implies that all of the contingencies and risk are insurable thus investors can freely insure against all of the fluctuations in their income stream, consumption patterns and income shocks. But later researches have proved that this assumption do not affect the effectiveness of the model in real world with imperfect market because model has been proved as effective in imperfect market as it has proved in perfect/complete market. The reason is that in the perfect market investors use financial market to make their consumption growth and overall consumption growth similar by diversifying the risks involved. While in the incomplete market scenario any such fluctuation are not completely adjusted by dynamic self-insurance and their consumption stream will be more volatile which will result in more risk aversion and thus investors will ask for higher risk premiums to streamline their consumptions. It is the point that highly supports Mehra and Prescott’s model of “Puzzle” as in the period studied equity premiums have been high in spite of the fact that variance in consumption was low during the period studied. No Transaction Cost Assumption:- Another assumption of Mehra and Prescott’s model is that they assume no transaction costs associated with buying, selling and trading of securities. While in the real world it is not so, as investors have to pay certain costs for analysis buying and short selling of securities, more over there are also certain costs associated with the trading of debt instruments for a common person, which increases the demand for return but practically these costs may somewhat affect the return on bonds but not as much the return on long term equity investment because “ If investors have long horizons the magnitude of trading costs will diminish over the life of the investment – consequently reducing the importance of these costs”. [NIELSEN 2006] Moreover demand for such a high return to offset transaction costs is only possible if the difference between the transaction costs of the both (equity and debt) is too high, which is not practically possible. Alternative Preference Structures:- Habit Formation :- There are two aspects of equity premium puzzle 1. Risk free rate is too low 2. Risk premium is too high. Consumption is habit forming, we want to consume more today than we did yesterday and tomorrow even more than today “This property of inter-temporal preferences is termed habit formation” [KOCHERLAKOTA 1996] This is because we get used to of that level of consumption and utility and make that a minimum standard for the next period and we have to achieve more than that to satisfy ourselves in the future. Thus marginal utility increases from one period to another. Investor knows that to increase his utility in future he needs more funds, which makes him more risk averse, which leads him towards saving today to fund his future needs. So when savings increase demand for saving decreases which results in lower risk free rates. This theory of habit formation implies that if investor will be highly risk averse then he will be indifferent between stocks and bonds. Moreover it also solves the low risk free rate aspect of the equity premium puzzle. Long Time Period :- To explain the high risk premiums over time Siegel 1992 formed a research from the period 1802 to 1990, below graph shows his research findings regarding risk free rate and equity premium and their growth during the period. [SIEGEL 1992] The graph shows that risk free rate has been stable during the starting period and then has fallen dramatically overtime, while during the same period real return on equity has been remarkably constant. So, it can be induced that higher equity premiums are more caused by dramatic decrease in risk free rate instead of increase in return on equity. Survivorship Bias :- Another factor that might affect the equity premium is the concept of survivorship, as in case of major disasters and catastrophic events returns are only available for survivors as there is a chance of complete abolishment of the stock exchange (many such events have been there in history). “Over a more recent horizon, there is historical evidence of at least thirty-six exchanges extant at the beginning of the century. More than half of these suffered at least one major hiatus in trading.” [BROWN, STEPHEN J. & STEPHEN A. 1995] So considering the element of survivorship bias riskiness of the US equities is understated as risk of survivorship is not taken into account into current data, and relevant adjustment required in risk premium is not made which will help to adjust the high equity premium to some extent. But this adjustment is only required when effect of such a catastrophic events is expected to be different on stock and bond market. But reality is that on the other hand such a risk is also faced by bond holders and they are equally vulnerable to such a risk. Although it seems to be a little bit unrealistic as bond are assumed to be default free and have fixed interest rate. To explain some historical examples given by Rjnish Mehra (1985) are quoted here. After the World War-II Germany had a period of hyperinflation due to which bond holders lost almost all of the value of their investment, while in 1920s in France during the administration of Henri Poicare bondholder lost almost 90% of the value of their investment. Whilst on the other end for the long term equity investors, impact of inflation is not such an intense as their dividends increase and face value of stocks also adjusts to the new level with the passage of time. So we can say that in scenario of inflation equity investors would be much better off than the bond holders who have to receive the same fixed rate and have fixed encashment value. Keeping up with Joneses :- Keeping up with joneses means that individuals utility not only depends upon his own consumption but also on the aggregate level of consumption in the economy. So his investment decision will also not only depend upon on the riskiness of his own consumption utility but also on the variability of aggregate consumption growth. So in this scenario investors find stocks unattractive due to per capita consumption risk aversion. Another aspect of keeping up with joneses is explained in these words “Catching up with the Joneses reduces an individuals desire to borrow against higher future consumption and hence lowers the real rate, but leaves an investor just as risk averse to contemporaneous shocks”. [SIEGEL & THALER 1997] Mean Reversion Aversion :- Long term investments are riskier than the short term investments, because period involved is longer so more changes are expected and large number of risk factors get involved, while in case of short term investment risks can be measured and determined to a larger extent as very limited changes may occur, that is why the return on long term investments is much higher than on the short term investments. But when the calculations are made on the historical data it shows that in the short run expected returns of equity and the debt instruments are more variable than these are in the long run. It is because economy works in the form of a cycle there are bad times after the good ones, and good ones after the bad ones. “In terms of stock prices this belief translates into the concept of (long-run) mean reversion, which states that a decline in stock prices is most likely to be followed by an upward price movement, and vice versa”. [SPIERDIJK & BIKKER 2012] So in the long run when we take an average of the variability of the returns of multiple periods it shows a less figure, because it also involves many good times when figure have been extremely low, which then adjusts the whole average to be low than the short run variability. It is also one of the reason than deepens the equity premium puzzle because measured risk associated with equity premiums is not as much high as the returns are by themselves. Which implies that long term equity investments are less risky than fixed income securities. Borrowing Constraints:- Another approach to explain the equity premium puzzle is the concept of borrowing constraints. As in case of borrowing constraints and transactions cost investors have to hold an inventory of bonds with them to maintain their liquidity and sooth consumption line. Models with borrowing constraints tend to bring the marginal rate of substitution of bonds closer to the without affecting equity premium as much. Constantinides et al. is an approach to resolve the equity premium puzzle. In this model the life style theorem has been also incorporated the life cycle theorem. In their model they have linked the attractiveness of equity with its relative income and consumption pattern of the investor. People have different incomes and different consumption patterns at different levels of their age, a young person with no income yet but expecting to earn in future will be much interested in securing his income and streamlining his consumption, so equity can be an attractive asset to hold and an effective tool for him to hedge his income fluctuations. While a middle aged person might be having a certain and well defined income stream and an equity income so his consumption will be affected by any fluctuation in equity income, so at this level consumption is highly correlated with equity and high rate of return on equity is required at this level. In the case of no borrowing constraints young people also has an option to get loan against their future salaries to which they can invest in equity to earn higher returns and thus will be able to pay interests on loans and earn an extra income as well. But on the other hand in this scenario demand for loans will increase which will increase the bond yield so middle ageds will have to shift their investment from equity to debt to maintain their income stream. This will result in a decrease in demand for equity by the elders and thus will bring equilibrium in both and thus both equity and bond returns will increase and equity premium will shrink. Liquidity Premiums:- Another approach used to explain the equity premium is the approach of “Liquidity Premium” this approach was used by Bansal and Coleman (1996). Their model of liquidity premium explains the concept of equity premium. In their model they assume that all of the assets except money are used to facilitate transactions, so this functionality of the assets affects their rate of return. They argue that relative to interest bearing checking account, transaction service return of money should equal the interest rate of interest bearing checking account. Taxes:- McGrattan and Prescott has also offered an approach to explain the phenomenon of equity premium puzzle. They use the tax rate for the explanation of equity premium puzzle. In their findings they argue that at least after the World War-II period equity premium has not been as much puzzling. The reason is that due to decrease in income tax rates individuals are more able to safeguard their earnings against taxes, due to which equity prices are higher in the period ranging from 1960 to 2000. Resultantly this increase in equity prices led to an increase in ex-post returns on equity than debts. No Premium:- There is also a school of thought that assumes there is no equity premium and hence also no equity premium puzzle. To explain this they use two different terms for equity premium 1. Ex-post 2. Ex-ante. Ex post is the actual or realized equity premium which the difference of return on equity and risk free rate. While ex-ante is the expected or forward looking equity premium which is expected to prevail in the future. After a bullish trend in market actual equity premiums are high while expected equity premiums are low, as compared to it after a downward trend expected returns tend to be higher while actual or real returns are low in this scenario due to the fact that returns on the stocks are mean reverting. Actual or realized equity premium may also be negative in some periods due to the time horizon they are measured in. Below graph shows the Ex-post equity risk premium during the period 1926-2000. Figure 2. Risk Premium, 1926–2000 Equity Risk Premium (%) 60 50 40 30 20 10 0 −10 −20 −30 −40 −50 A. Realized Equity Risk Premium per Year 26 36 46 56 66 76 86 96 00 Year-End [MEHRA 1985] But it must be kept in mind that over the long run equity premiums tend to be positive and are usually same over the years and tend to be greater than the risk free rate prevailing in the economy. Comments:- In spite of a lot of work on the phenomenon of the equity premium puzzle it is the reality that researchers have been unable to resolve the puzzle and it with stands. From my point of view the time horizon (90 Years) used by Mehra and Prescott is too long to yield effective results. Research will have been more effective and providing realistic results if the study would have been made using a standard time span of 20-25 years, means the period of 90 or hundred years should be divided into four to five slots to get results of each period. Because the period studied (1889-1978) also includes the two world wars which changed the world in every aspect and had immense result on each segment especially the economy of the countries involved. So the results of the study are greatly affected by the wars and post war events and policies. Moreover considering the average human life (50-60 years) in the current world making 90 years investment decision is quite rare and in fact impractical. So if I and also 99% of other people on planet have to make an investment today it will be maximum for the 20 to 25 years period and most probably than thirty years in any case. So to make my investment decision your average equity risk premium of 90 years is of no use to me, so it have been more useful if I can get information about the average historical risk premium for my required time span. Moreover, as consumption is habit forming and as our standards of living automatically readjusts to our new income level so the money I had today will be most probably consumed today to make my standard of living better or in the near future to maintain that level, and the remaining one I will invest for my children’s education, marriage or for my own retirement (to make future secure). The equity premium that an investor earns on his long term investment includes his compensation for taking risks and financial/ liquidity sacrifice for long period of time, more over the excess can be named as his reward for making the choice and taking ownership. It can be explained by the following example. Assume that a firms goes public and to finance a major project needs $100000(assuming that it is the only project firm is going to complete this year). It issues 50000 shares of a par value of $2 per share, but as the firm is new so investors are not willing to buy its share and only 20000 shares are sold. To get further financing the firm issues 30000 of $2 bonds with one year maturity and having an annual rate of return of 1%. At the year end firm announces a net profit after interest and taxes of $400000 and announces a cash dividend of 2 dollars per share. So what I have earned that is not only reward for my own investment but it also includes the part income earned form debt money invested in the project which bond investors have lost due to their risk averse preference and not taking the risk. So what an equity investor earns also includes the share forgone by the debt investor to keep himself same. REFRENCES INVESTOPEDIA.com, Accessed on January 3, 2013. ˂http://www.investopedia.com/terms/e/epp.asp#axzz2GuvXNHzH˃ MEHRA RAJNISH & PRESCOTT C. EDWARD,1985“The Equity Premium, A Puzzle” Journal of Monetary Economics 15, North Holland. WEIL PHILIPPE,1989 "The Equity Premium Puzzle and the Risk-Free Rate Puzzle",Pg.401 Journal of Monetary Economics 24, North Holland. NIELSEN I. LINE, 2006 “Explaining the Equity Premium Puzzle Using Myopic Loss Aversion” Pg.14 Copenhagen Business School. KOCHERLAKOTA R. NARAYANA, 1996 “The Equity Premium: It’s Still a Puzzle”Pg.55, Journal of Economic Literature, SIEGEL J. JEREMY & THALER H. RICHARD, 1997 “The Equity Premium Puzzle” Pg.196 The Journal of Economic Perspectives, Vol. 11. SIEGEL J. JEREMY, 1992 “The Equity Premium: Stock and Bond Returns since 1802” Pg.34 Financial Analysts Journal, Vol. 48. BROWN, STEPHEN J., WILLIAM N. GOETZMANN & STEPHEN A. ROSS, 1995 "Survival", Journal of Finance. SPIERDIJK LAURA & BIKKER A. JACOB, 2012 “Mean Reversion in Stock Prices: Implications for Long-Term Investors”Pg.1, Tjalling C. Koopmans Research Institute Utrecht School of Economics. BANSAL R. % J.W. COLEMAN, 1996. “A Monetary Explanation of the Equity Premium, Term Premium, and Risk-Free Rate Puzzles.” Journal of Political Economy. MCGRATTAN, E.R. & E.C.PRESCOTT, 2001. “Taxes, Regulations, and Asset Prices”, Federal Reserve Bank of Minneapolis. THALER H. RICHARD, 1999 “Mental Accounting Matters”Pg.183 Journal of Behavioral Decision Making THALER, R. et al, “The Effect of Myopia and Loss Aversion on Risk Taking: An Experimental Test”, Quarterly Journal of Economics. SWEDROE LARRY, 2002 “Frequent Monitoring of Your Portfolio Can Be Injurious to Your Financial Health”Accessed on January 04,2012. ˂http://www.indexfunds.com/articles/20021015_myopic_com_gen_LS.htm˃ Read More