[PEN-L:12010] equity premium puzzle

[James Devine <jdevine@xxxxxxxxxxxxxxx>]

In Gary Mongovi's review of Doug Henwood's book WALL STREET, he writes that
neoclassical economists >have no solution, for example, to the so-called
equity premium puzzle--the fact that stock shares have historically yielded
a return well above the returns to bonds and real assets, well above the
real rate of economic growth and well above what can be explained by the
higher risk of equity investments. <

In addition, on page 305 of his excellent book, Doug uses the existence of
the equity premium puzzle to argue against putting social security funds
into the stock market.

While I agree that SS funds shouldn't be risked that way, I am skeptical of
this use of the equity premium puzzle. I am not convinced that the higher
risk of equities doesn't explain their historically higher return. (Also, I
see no reason why the equity premium won't persist in the long haul just
because there's no good theory about its existence in the past.)

I asked an LMU finance professor [Chuck Higgins, who attended UC-Riverside
years ago] about this and he responded:

>The historic market premium of equities over short-term risk free yields
has historically been 8.8 percent [Ibbotsen & Sinquefield].

>I would (probably as a minority in finance--but among the portfolio
theorists and risk theorists) argue that part of that premium is not just
the CAPM [capital assets pricing model --JD] market premium, but also the
more general gambling/insurance premium wherein the median (MEDIAN!)
expected price is the log-normal equivalent of the expected utility of a
risk a[d]verse function.

>Thus premium is not just for volatility--but also for utility preferences
for avoiding volatility.  Shiller did a very good job in reviewing whether
there has been an excess market premium.  But as he notes regarding the
market's extreme outliers:  in 1942 and 1974 we DID think the world WAS
going to end!!<

The references are: >  Robert J. Shiller, "Do Stock Prices Move Too Much to
Be Justified by Subsequent Changes in Dividends?" AER (June 1981), pp.
421-436.

and >Robert J. Shiller, "Theories of Aggregate Stock Price Movements,"
Journal of Portfolio Management (Winter 1984), pp. 28-37.<

What does pen-l (and Doug) think of this kind of explanation?



in pen-l solidarity,

Jim Devine jdevine@xxxxxxxxxxxxxxx
http://www.lmu.edu/acad/personal/faculty/jdevine/home.html
Econ. Dept., Loyola Marymount Univ.
7900 Loyola Blvd., Los Angeles, CA 90045-8410 USA
310/338-2948 (daytime, during workweek); FAX: 310/338-1950
Economic theories "have become little more than vain attempts to revive
exploded superstitions, or sophisms like those of Mr. Malthus, calculated
to lull the oppressors of mankind into a security fo everlasting triumph."
-- adapted from Percy Bysshe Shelley.