Equity premium puzzle

The equity premium puzzle refers to the inability of an important class of economic models to explain the average equity risk premium (ERP) provided by a diversified portfolio of equities over that of government bonds, which has been observed for more than 100 years. There is a significant disparity between returns produced by stocks compared to returns produced by government treasury bills. The equity premium puzzle addresses the difficulty in understanding and explaining this disparity. This disparity is calculated using the equity risk premium:

The equity risk premium is equal to the difference between equity returns and returns from government bonds. It is equal to around 5% to 8% in the United States.

The risk premium represents the compensation awarded to the equity holder for taking on a higher risk by investing in equities rather than government bonds. However, the 5% to 8% premium is considered to be an implausibly high difference and the equity premium puzzle refers to the unexplained reasons driving this disparity.

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