The Equity Premium
Brad DeLong shares his lecture notes on the equity premium:
There is, somewhere, a marginal investor: somebody just about indifferent between stocks and bonds. If the expected return to stocks were a little higher, he or she would move more money to stocks. If the extra risk associated with holding stocks were a little lower, he or she would move more money to stocks. In either case, that increase in demand for stocks would push their prices up, and so push the relative returns on stocks–which are the dividends that will be paid out on stocks in the future divided by the stocks’ current price–down. But this marginal investor fears the risk as much as he or she values the return, and so does not move more money into stocks, and that is why the current price of stocks and the current value of the equity risk premium are what they are.
Now let’s look at patterns of returns over the twentieth century, and try to figure out what this marginal investor has been seeing and thinking to make the equity risk premium what it has been, and then try to figure out what the current equity risk premium is.
…[I]n only 1% of the years in the twentieth century would investing in bonds for twenty years outperformed investing in stocks; and in that year–1929–the twenty-year returns to bonds would be only 8% ahead of the twenty-year returns to stocks. The equity premium puzzle is not due to the specific liquidity or collateral or other institutional properties of Treasury bills that make them especially valuable.
We have climbed into the box of the equity premium puzzle, which has now been locked and sealed with us on the inside. How are we going to get out of it?
See Brad’s post for the rest…