Question

Explain Equity Premium Puzzle explicitly? How can behavioral finance try to explain this anomaly? Refer to the necessary terminology

Answer 1

Equity premium puzzle explicitly means that the risk premium of equity as a class over treasury bonds.

Equity risk premium is reflecting the outperformance of stocks over bonds and gold in historical past and it has been reflected through various empirical evidences that equity has outperformed the bonds and golds in a longer time frame and provided excessive rate of return that has led to a premium which is being allocated to the equity as a asset class so it has remained a puzzle till date according to this philosophy that why this equities even though they are are trading at those high valuations, they are not preferred by payment of low risk premium, so they are always reflecting a high risk premium due to risk aversion of the investor and it has also reflected that investor are more likely to invest in risk free assets.

This behaviourial bias is reflecting the the risk aversion of various individuals as an investor because they do not want to invest in equity because of the high risk which is associated with equity and there is a risk premium in the valuation of equity and risk free treasury bonds which can be seen through equity premium of almost 8% in United States