The Equity Premium Puzzle: A Suggested Solution
Most investors are free to invest in either stocks or bonds, so one would expect the return of both investments to be similar. It is an obvious argument, at least to an economist, but the conclusion does not appear to be true. In the U.S. over the past century, stocks have consistently outperformed bonds. This is the Equity Premium Puzzle.
A variety of explanations have been offered. The most obvious is that the return of stocks, both individual stocks and stock portfolios, is more uncertain than the return of bonds, at least over the short run, so risk averse investors would be willing to accept a lower return on bonds in exchange for lower risk. Attempts to estimate how risk averse investors would have to be to explain the observed premium, however, produce implausible answers:
To quantify the level of risk aversion implied if these figures represented the expected outperformance of equities over bonds, investors would prefer a certain payoff of $51,300 to a 50/50 bet paying either $50,000 or $100,000.[1]
A variety of other explanations have been offered but none appears to be generally accepted.
I have another one.
Imagine a market where many investors are insider traders on a small scale, in an economic but not necessarily a legal sense. I know more than the market about the firm I work for. You know more than the market about a firm you have repeatedly had dealings with. He knows more than the market about a technology he has worked with extensively that will affect the performance of several firms.
Each person invests some of his money where he has an edge, buys a stock that is going to go up or sells short one that is going to go down. By the standard analysis of insider trading, he makes an above market return. Because he is risk averse he wants to diversify his investment, so part of his money goes into other investments. His marginal return is the return he can get without inside knowledge, his average return is a suitably weighted average of that and his insider return. Bond investments only have to do as well as his marginal investments, so the return on bonds is lower than the average return on stocks.
When I first came up with the idea, someone I described it to offered a proof that it could not be true, one that at the time seemed convincing. My argument implies that everyone, the investor without inside knowledge and the investor with inside knowledge making marginal investments, is getting less than the average return. Why can’t he buy a random collection of stocks, in the limit a millionth of a percent of the stock of every company, and so guarantee himself the average return?
That proves too much, only that my explanation of the equity premium puzzle is inconsistent with rational behavior by investors but also that an insider cannot profit by his inside knowledge: If some insiders are getting an above average return, everyone else must be getting, on average, a below average return, and anyone who is could get an average return by buying stock at random.
The solution to the paradox is that it is not possible for every uninformed investor to end up with an equal share of every company on the market because some of those shares, the shares of companies particularly likely to go up, belong to insiders. That explains both how it is possible for insiders to make an above average return and why my explanation of the Equity Premium Puzzle is not inconsistent with investor rationality.
Whether it is the correct explanation, of course, I do not know.
Comments welcome.
[1] Mankiw, N. Gregory; Zeldes, Stephen P. (1991). "The Consumption of Stockholders and Nonstockholders". Journal of Financial Economics. 29 (1): 97–112.