Equity Premium Puzzle

It has been shown that equity securities offer a much higher annual return than bonds. Over the past 100 years, the average yield on US equities has been six times higher than for US government bonds.

The Equity Premium Puzzle refers to the empirical observation that the yields on stock markets in the last hundred years have been higher than those for government bonds. In particular, the average risk premium for US equities in that period would amount to about 6%, where the average yield of US short-term government bonds (considered a reasonable approximation of risk-free yield) would be about 1%.

Why do you think most people invest in bonds and not in stocks? This kind of behaviour is not rational but derives from emotions like fear and insecurity.

The equity premium puzzle (the riddle of the premium associated with equity securities) is a formula introduced by Mehra and Prescott in 1985 to emphasise the fact that investors consider equity investments to be excessively risky.

Investors' judgment is based on the fact that the value of equity securities is highly variable, especially when compared to other, safer types of investment (for example, government bonds), but the equities allow a much higher profit in the long run.

A different theory, explained by Benartzi and Thaler (1995), argues that investors would not be adversely affected by high variability in equities' yield, but rather, by the possibility of recording a loss. In other words, investors are primarily worried about their shares losing whenever they decide to check their investment performance.

We have, in the investors, an association of fear and aversion to losses, and all for a significant reason. Often, investors look too frequently at the performance of their portfolio, and, normally, there is a big difference between a bond portfolio and a stock one. The one for equities is more volatile and oscillates more frequently.

Benartzi and Thaler determined that the average investor checks the performance of his portfolio at least once a year. However, during the year, it often happens that equity securities have less of a yield than bonds, even though they are capable of recovering a loss and overcoming bond yields when they grow in terms of value.

So, if a person continues to look at their portfolio often, it becomes evident that this will only increase their fears and uncertainties, leading to continuous investment and disinvestment of their portfolio.

What do I want to tell you? Spending too much time in front of your computer does not necessarily mean making more money, on the contrary, it might be harmful. Once you have established your profit and your potential loss, it is useless to keep standing in front of the chart, “praying for the price” for ages. All that does is create fatigue and stress; and if you are not thinking straight, you will not be able to read the markets correctly. Telling you this is a man who used to spend 14-15 hours a day in front of a monitor, for several years. I can assure you that this did not result in more money entering my trading account.

So, what do you have to do? You are better off spending more time analysing the market, evaluating the situation and checking all the parameters first. Then, once you have invested, it is pointless to keep watching the chart (especially because an investor is not a day trader).

What you actually have to do, and which you will see explained later on, is that, once you have closed an investment, you should reanalyse the trade by understanding whether or not you have committed any mistakes.