Equity Premium Puzzle

The equity premium puzzle is a financial phenomenon that highlights the unexpectedly high returns of stocks compared to risk-free assets, such as government bonds, over long periods. Despite the higher returns, the observed equity premium, which is the difference between stock returns and bond returns, is larger than can be explained by traditional financial theories. Economists puzzle over why investors do not hold more stocks if the returns are significantly higher than less risky assets, suggesting that factors like risk aversion, market imperfections, and psychological biases might play a role.

Example

Historical data shows that U.S. stocks have delivered an average annual return of about 7% above government bonds, a premium that remains difficult to justify solely by risk factors.