Equity Premium Puzzle Essay Example | Topics and Well Written Essays - 2750 words

Equity Premium Puzzle - Essay Example Equity premium is meant to cushion stock investors against the risk of losing their investment portfolios (Siegel and Thaler, 1997, p. 195). However, variations in gain between government bonds and stocks are quite vast and yet government bonds also bear some risk especially the risk associated with inflation (Ben-Haim, 2006). People invest their money to benefit from the gain in the value of their assets. However, many people continue to invest in government bonds where there is such small gain than in stock. This has resulted to a dilemma to the economists who have been unable to understand why many people still prefer government bonds despite the huge returns in stocks as compared to bonds (Siegel and Thaler, 1997, p. 192). The investment decision is influenced b perceived risk, investors’ ability to bear risk, investment period, investor satisfaction and utility behaviour. As stated earlier equity premium is the difference in gains between stocks and risk-free assets such as governments’ bond or security bills. The government bonds are believed to bear no risk while ordinary stocks are rated as the most risky venture (Glyn, 2006, p.153). Due to this perception of risk, many people opt to invest their money in government securities where they have guarantee for small gains rather than investing in stocks with prospect for enormous gains but bearing vast risk. Equity premiums are meant to shield investors against enormous threat associated with the perceived loss on investment in the stocks (Siegel and Thaler, 1997, p. 195). This variation is too huge hence economists have never come into consensus as to why people continue to invest in government bonds which normally have low yields compared the stocks. The economists have assumed that investors must have immense risk evading attitude (Ben-Haim, 2006). This is because in the real sense people would invest in stocks which have higher probability for gigantic returns than gains in bonds value. Ho wever, since people would want to keep away from risk of any form, they opt to invest in bonds where they have a better chance to gain than in stocks. The economists have also doubted whether stocks truly bear any equity premium, and whether the real gain from the investment reveal value equivalent to the equity premium (Siegel and Thaler, 1997, p. 193). If this is true then what makes investors fail to invest in stocks which bear gigantic equity risk premiums? The investors’ decisions on what type portfolio they should purchase are either influenced by personal factors or market factors (Ben-Haim, 2006). This has also raised concern over the existence of equity premium puzzle. In Siegel and Thaler (1997, p. 193), the dilemma regarding the investor’s decisions could only be a matter of individual taste and preference which cannot be influenced by the market conditions. This difference in gains between risk-free bonds and stocks investments is explained by economists us ing economic yardstick replica (Siegel and Thaler, 1997, p. 192). To determine this variation economists use â€Å"standard equilibrium model† in which the individual’s willingness to utilize resources vary from one period to another, when the risk deterrence attitude remains unaffected The gauge used in this approach is the comparative risk deterrence factor named A. Therefore, the hypothesis was that a decline in utility by 1% should result to an increase in marginal value of the income of the