The equity premium puzzle (EPP) refers to the substantial and persistent outperformance of a broad stock market index portfolio relative to conservative benchmark investments, largely consisting of short-term U. S. Treasury bills. This outperformance is so strong that it is difficult to explain using traditional financial theories and models. Historically, the premium has hovered around 5-8%, making this excess return challenging to reconcile with common financial wisdom and fundamentals.

The prospect theory, proposed by psychologists Daniel Kahneman and Amos Tversky, provides an explanation for the equity premium puzzle. This theory suggests that investors have an anxious relationship with stocks, which causes them to work to lower their expected losses and to avoid too much risk. According to the prospect theory, the investor’s own psychological perspective helps explain why raising their required rate of return increases the amount of risk they are willing to take on.

The importance of personal debt also plays a significant role in the EPP. High levels of personal debt create an incentive for investors to take on more stock market risk, which drives the premium up. Additionally, liquidity - the ability of an investor to quickly convert investments into cash - is an important factor in explaining the equity premium puzzle. Investors with high levels of liquidity are more likely to adjust their portfolios in the short-term, which includes taking on more stock market risk.

Government regulation and taxation also factor into the EPP. For example, the tax system in the U. S. reduces the after-tax returns of stock markets, inducing investors to take on more risk to compensate. Additionally, regulations around certain investments can cause investors to stay away from less liquid and riskier investments, pushing the equity premium higher.

The EPP can also be explained by previous lack of knowledge about investments. Investors in the past have not had access to the same level of information that modern investors have, so they are more likely to make decisions based on previous failings or experiences without having the ability again to research and understand the investments they were making. Furthermore, the decline of the US dollar in relation to gold during this period can also help explain the EPP. As the dollar became increasingly unstable and gold prices rose, investors were incentivized to move away from the dollar in favor of gold or other resources, pushing stocks to become the asset of choice.

The equity premium puzzle is also explained through problems related to diversification and population growth. When investors diversify into riskier portfolios, they are rewarded with excess returns. Additionally, population growth can create demand shocks, driving investors to take on more risk in an effort to meet their returns goals.

In sum, the equity premium puzzle is a difficult and complex problem to explain. While there are several theories that can help account for this trend, no comprehensive solution exists. Therefore, it is important for investors to be well informed of the risks and benefits of stock markets, as well as the economic and financial environment in which their investments are made.