======Equity Premium Puzzle======
The Equity Premium Puzzle is a famous conundrum in finance that questions why the long-term returns on [[stocks]] (equities) have been so much higher than the returns on ultra-safe government [[bonds]]. This gap in returns is called the [[equity premium]]. For over a century in the United States, this premium has been a whopping 6-7% per year. The "puzzle," first highlighted by economists [[Rajnish Mehra]] and [[Edward C. Prescott]] in 1985, is that this premium is //far too large// to be explained by traditional economic models. According to these models, for investors to demand such a high extra return for holding stocks, they would have to be absurdly [[risk-averse]]—so fearful of any risk that it contradicts how people behave in other areas of their lives. In simple terms, the reward for taking on the risk of the stock market seems disproportionately, almost suspiciously, high.
===== The "Puzzle" in Numbers =====
Imagine you have two savings accounts for the next 50 years.
  * Account A pays a guaranteed 1% interest per year. This is like a government bond, your [[risk-free rate]].
  * Account B's interest rate bounces around. Some years it’s -20%, other years it's +30%, but on average, it pays 7% per year. This is like the stock market.
Over time, Account B will make you vastly wealthier due to the power of [[compounding]]. The 6% difference between them is the equity premium. The puzzle is this: why would any long-term investor ever choose Account A? Yet, historically, investors have acted so cautiously that they've demanded this huge 6% "bribe" to stomach the volatility of stocks. Standard economic theory says a premium of around 1% should have been enough to convince a rational person to take the leap. The massive gap between the theoretical 1% and the actual 6-7% is the heart of the puzzle.
===== Trying to Solve the Riddle =====
Economists and psychologists have proposed several compelling explanations for why this premium is so large. Most solutions move away from the idea of a perfectly rational "economic man" and toward a more realistic, psychologically-driven investor.
==== Behavioral Finance to the Rescue? ====
The most popular explanations come from the field of [[behavioral finance]], which studies how human psychology affects financial decisions.
=== Myopic Loss Aversion ===
This brilliant theory, proposed by [[Shlomo Benartzi]] and [[Richard Thaler]], combines two powerful psychological quirks:
  * **[[Loss Aversion]]:** A cornerstone of behavioral economics, this is the idea that we feel the pain of a loss about twice as intensely as we feel the pleasure from an equivalent gain. Losing €100 feels as bad as gaining €200 feels good.
  * **Myopia:** This is just a fancy word for short-sightedness. Many investors check their portfolios far too often—daily, weekly, or monthly.
When you combine these, you get a recipe for fear. Because the stock market is volatile, the more frequently you check your portfolio, the more likely you are to see a small loss. Thanks to loss aversion, each of these small, frequent paper losses causes significant psychological pain. This constant pain makes stocks //feel// far riskier than they actually are over the long run, leading investors to demand a much higher premium as compensation for all that emotional distress.
==== Survivorship Bias ====
Another compelling argument is that our data is skewed by [[survivorship bias]]. The massive equity premium we observe is primarily based on the US market, arguably the most successful economic story of the 20th century. We are measuring the returns of a winner.
What if we included the stock markets that //didn't// make it? Think of investors in Russia in 1917, China in 1949, or Germany in 1945, whose investments were wiped out by war and revolution. If you average in these catastrophic failures, the //true// global equity premium that an investor could have expected would be much lower. According to this theory, investors aren't just pricing in the normal volatility of a market like Wall Street; they are subconsciously demanding compensation for the small but terrifying risk that the entire system could collapse.
===== What This Means for Value Investors =====
For a [[value investor]], the equity premium puzzle isn't a problem; it's an opportunity. It's a giant signpost pointing to the market's irrationality, which is the very thing value investors exploit.
  * **Get Paid for Being Patient:** The puzzle suggests that the market offers a massive bonus to those who can remain rational and patient. If other investors are irrationally scared by short-term volatility (myopic loss aversion), they will sell stocks for less than their [[intrinsic value]]. Their fear is your discount. The equity premium is your reward for staying calm when others are panicking.
  * **Lengthen Your Time Horizon:** The puzzle is almost entirely a short-term phenomenon. The "risk" that scares myopic investors melts away over a long [[time horizon]]. As the legendary investor [[Warren Buffett]] advises, if you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes. This long-term mindset allows you to ignore the noise and collect the premium.
  * **Stop Checking Your Portfolio:** The theory of myopic loss aversion provides a clear, actionable piece of advice: stop looking at your stocks every day! By checking less frequently—say, quarterly or annually—you can insulate yourself from the psychological pain of meaningless short-term fluctuations and make better long-term decisions.