Equity Premium Puzzle

Historically, equities have offered a much higher annual return than bonds. In the 90 years studied by Mehra and Prescott (1889–1978), the average real return on US equities was about 7% a year, against less than 1% for short-term US government securities.

The Equity Premium Puzzle refers to the observation that the premium earned by equities over government bonds has been far larger than standard economic models can explain. In the period studied, the average risk premium of US equities amounted to about 6%, whereas the average real yield on short-term US government securities (considered a reasonable approximation of the risk-free yield) was less than 1%.

Why do you think most people prefer bonds to stocks? This behaviour is not rational but derives from emotions such as fear and insecurity.

The equity premium puzzle (the riddle of the premium associated with equity securities) was identified by Mehra and Prescott in 1985. It highlights that investors seem to consider equity investments excessively risky.

Investors’ judgement 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 equities offer a much higher profit in the long run.

A different explanation, put forward by Benartzi and Thaler (1995), argues that investors are bothered not so much by the high variability of equity returns as by the possibility of recording a loss. In other words, investors are primarily worried that their shares will show a loss whenever they check their investment performance.

So investors associate fear with aversion to losses, and for a good reason. Investors often look too frequently at the performance of their portfolio, and there is normally a big difference between a bond portfolio and a stock portfolio: the equity one is more volatile and fluctuates more often.

Benartzi and Thaler found that investors behave as if they evaluated their portfolios about once a year. During the year, however, it often happens that equities yield less than bonds, even though they are capable of recovering a loss and outperforming bonds when their value grows.

So, if a person keeps looking at their portfolio, this will only increase their fears and uncertainties, leading to continuous buying and selling.

What am I trying to tell you? Spending too much time in front of your computer does not necessarily mean making more money; on the contrary, it can be harmful. Once you have set your profit target and your potential loss, it is useless to keep staring at 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. I am telling you this as a man who spent 14-15 hours a day in front of a monitor for several years, and I can assure you that it did not bring more money into my trading account.

So, what do you have to do? You are better off first spending more time analysing the market, evaluating the situation and checking all the parameters. 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, as you will see explained later, is this: once you have closed an investment, re-analyse the trade to understand whether or not you made any mistakes.