The stock market’s reaction to the credit crisis of 2008 provides new evidence for solving the hotly debated and intensely researched equity risk premium puzzle. Explanations of the risk premium form the foundation for understanding price dynamics and portfolio allocation decisions. The book develops the two major themes in explanations of the equity risk premium, namely, risk-based and non-risk-based stories. The book also explores the equity premium’s countercyclicality with respect to business conditions and its tendency to increase after periods of high price-to-earnings ratios.
The stock market’s reaction to the credit crisis of 2008 provides new evidence for solving the hotly debated and intensely researched equity risk premium puzzle. Simply stated, empirical evidence documents higher risk-adjusted equity returns than financial theory predicts. Rethinking what we mean by the equity puzzle may be appropriate, however, when the stock market wipes out several years’ worth of cumulative returns in a matter of weeks.
Handbook of the Equity Risk Premium was edited by Rajnish Mehra, a professor of finance at the University of California, Santa Barbara. Widely acknowledged as the father of the equity premium debate, Mehra is the ideal scholar to bring together research from many leading authorities on the subject. His efforts have resulted in a lengthy treatise consisting of 14 articles, as well as commentary from discussants’ presentations at a major conference on the puzzle. Readers can obtain a good overview of the controversies, however, from the first three articles. The volume also contains two good review articles on global empirical evidence concerning the risk premium.
Because the articles were written for an academic audience, with extensive exploration of subtle issues of modeling, certain findings may be inaccessible to many practitioners. The importance of the work, however, is undiminished. Explanations of the risk premium form the foundation for understanding price dynamics and portfolio allocation decisions. The book develops the two major themes in explanations of the equity risk premium, namely, risk-based and non-risk-based stories.
Risk-based explanations of the equity risk premium emerge from the fact that measured excess returns imply abnormally high risk aversion. The objective of such explanations is to provide a framework that does not rely on this abnormal risk aversion. Research that pursues this theme falls into four categories: preference-based theories, disaster scenarios, trading frictions, and model uncertainty—all of which provide compelling evidence that the high risk premium is rational.
Preference-based theories try to modify the modeled behavior of agents in the economy to make them more sensitive to periods of low consumption. The remodeled behavior can be a rationale for a higher-than-standard premium for assets that move with the business cycle. For example, sensitivity to losses or to habit-based consumption behavior will produce a more sensitive response to equity risks than traditional models predict. In the Handbook of the Equity Risk Premium , this behavioral approach is discussed in a detailed article on loss aversion and narrow framing of risk. This discussion represents an interesting intersection between finance and behavioral models.
Disaster scenario stories, a compelling area of current research, tie in closely with the preference story. In this explanation, a combination of loss aversion and extremely bad outcomes leads to heightened premiums, especially if investor behavior is influenced by a long memory. If expectations focus on extreme scenarios, investors will demand seemingly excessive compensation, even during normal times. Years of stable returns may not offset the view that a crash or depression is still a possibility. Unfortunately, the Handbook of the Equity Risk Premium does not thoroughly explore this explanation, which has become the talk of the market.
Trading frictions may magnify the equity premium because the market cannot effectively insure against bad states of nature. Incomplete markets in the form of trading restrictions and collateral or borrowing constraints are clearly important issues across generations and in certain periods. The inability to insure against unemployment, which rises when equities fall, will generate a demand for higher excess returns. Furthermore, if credit markets seize up, investors will be unable to hedge risks or alter their portfolios; thus, an extra equity premium will be required.
Model uncertainty and expectation formation are also regarded as important explanations for the equity premium. The Handbook of the Equity Risk Premium presents compelling evidence that long-run growth uncertainty has a significant impact on the equity premium. The decline in the equity premium in recent years is consistent with the “great moderation” in the business cycle. If the period of economic calm is over and the ability to develop models to forecast future cash flows is diminished, asset price premiums will clearly increase. Model and expectation uncertainty is a subtle but critical issue that could have been further developed in this book. For practitioners, the process of expectation formation and forecast uncertainty are more relevant for explaining the premium in asset prices than is a focus on the behavior of consumption functions.
Non-risk-based explanations of the equity premium focus on borrowing constraints and generational differences in consumption and borrowing behavior, as well as on structural issues. The environment matters even for the simple question of whether U.S. Treasury bills are the appropriate measure of the marginal rate of intertemporal substitution—that is, the risk-free rate. Government regulation and taxes both affect how the premium is calculated. If modeled correctly, some of these technical issues will partially solve the puzzle.
The Handbook of the Equity Risk Premium also explores the equity premium’s countercyclicality with respect to business conditions and its tendency to increase after periods of high price-to-earnings ratios. The book’s explanations of the return for risk in equities are all the more valuable in the context of recent stock performance because they further establish the link between macroeconomics and finance. Readers should not miss this message because the separation of finance from macroeconomic behavior is not as clear-cut as commonly supposed. Consumption behavior, growth volatility, and the ability to protect against economic downturns are all macroeconomic issues that affect the equity premium. Worthy of special mention is John Cochrane’s well-written article on the macroeconomics–finance link, “Financial Markets and the Real Economy.”
Although many of the proposed explanations for the equity premium puzzle seem valid, little effort has been made to unify all the thinking on the subject. This book’s review articles detail what research has been done, but still missing is a synthesis to tell us which approaches are most compelling and useful, both currently and for future research. An article on the practical implications of the theoretical research also would have been helpful. Readers are left to determine for themselves the relative importance of each explanation.
In the end, history will be written by the winners. We do not yet know which theories will prevail as an explanation of the return for risk in light of the new performance information emerging from the financial crisis. Indeed, we may be faced with a new equity premium puzzle—namely, why there was not more compensation for risk before the recent debacle.
At this point, we can conclude only that the supposed magic of the long-term buy-and-hold strategy is suspect and that investors will need a new paradigm to construct their portfolios. This paradigm may be a variation of passive investing or perhaps a new form of active investing that responds to such factors as changes in the business cycle. Even though important issues remain unresolved, this book offers intriguing explanations for investors’ need to be generously compensated for the risk of holding equities.