Posted by: Dirk | May 30, 2008

The equity premium puzzle

Recent research has stressed the fact that equity returns are consistently higher than bond returns (see DeLong/Magin 2008, Acheson et al. 2008). Here is the abstract of DeLong/Magin:

For more than a century, diversified long-horizon investors in America’s stock market
have invariably received much higher returns than investors in bonds: a return gap
averaging some six percent per year that Rajnish Mehra and Edward Prescott (1985)
labeled the equity premium puzzle.

Apparently, the equity premium puzzle already existed in nineteenth-century Britain. Acheson et al. find an old puzzle connected to the equity premium puzzle:

Finally, unlike modern-day investors, nineteenth-century investors earned most of their return from dividends rather than capital appreciation. This raises the question as to why dividends have disappeared in the last three decades. Possibilities include the changing characteristics of firms, increased use of stock repurchases, improvements in investor protection law, and better alignment of managerial interests with those of shareholders.

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