The equity premium puzzle is still unsolved. The answer to your question is that nobody knows the answer. Stocks shouldn’t have gone up historically, none of our current theories are capable of explaining why stocks did go up. Equivalently, stocks were massively underpriced over the last century or so and nobody knows why.
If you don’t know why something was mispriced in the past, you should be very careful about asserting that it will or won’t continue to be mispriced in the future.
The classic answer is risk. Stocks are riskier than bonds, so they should be underpriced (and therefore have higher returns) than bonds.
But we know how risky stocks have been, historically. We can calculate how much higher a return that level of risk should lead to, under plausible risk tolerances. The equity premium puzzle is that the observed returns on stocks is significantly higher than this.
Read through the wikipedia page on the equity premium puzzle. It’s good.
Why shouldn’t have stocks gone up historically? Isn’t there more real wealth today than during the days of the East India Company? If a stock represents a piece of a businesses, and those businesses now have more real wealth today than 300 years ago, why shouldn’t stock returns be quite positive? To be honest I’m bewildered by this perspective that stocks should never go up—I’ve never seen anyone in finance academically or professionally entertain this idea, so I’m surprised to hear you say “no one knows the answer,” as if it’s a common puzzle in the field. Why some stocks go up more than others is a good and open question, but that’s one of relative valuation, not whether market returns on an absolute are greater than zero.
People have grown accustomed to there being an equity premium to the extent that there’s a default assumption that it’ll just continue forever despite nobody knowing why it existed in the past.
>Isn’t there more real wealth today than during the days of the East India Company? If a stock represents a piece of a businesses, and those businesses now have more real wealth today than 300 years ago, why shouldn’t stock returns be quite positive?
I simplified a bit above. What’s unexplained is the excess return of stocks over risk-free bonds. When there’s more real wealth in the future, the risk free rate is higher. Stock returns would end up slightly above the risk-free rate because they’re riskier. The puzzle is that stock returns are way, way higher than the risk-free rate and this isn’t plausibly explained by their riskiness.
The equity risk premium puzzle is about a very different question, no? The equity premium puzzle is a puzzle because of how large the equity premium is to bonds, but it is totally expected that there is an equity premium or that bond and equity returns are positive. Concretely, the puzzle asks, why do equities earn 8% if the risk-free rate is 2%, instead of 3%? The puzzle is that 6% spread is much larger than what standard financial theory predicts (although a lot of the dispute ends up being around the right parameterization and benchmarks). But standard financial does predict (a) an equity premium to the risk-free rate and (b) positive returns for both equities and bonds.
I think you get to that understanding in your last sentence (“stock returns are way, way higher than the risk-free rate”), but this is a much different statement than “stocks shouldn’t have gone up historically” or “people have grown accustomed to there being an equity premium to the extent that there’s a default assumption that it’ll just continue forever despite nobody knowing why it existed in the past.” I don’t want to be a pedant, but those are much different statements, because they state that the absolute return on stocks should be 0, and that the positive return of equities is some puzzle. Maybe I’m misunderstanding you, but the straightforward interpretation of what you were saying is quite bold, and not something I’ve heard of before or have seen on wikipedia (including what you linked).
The vast majority of the equity premium is unexplained. When people say “just buy stocks and hold for a long period and you’ll make 10% a year”, they’re asserting that the unexplained equity premium will persist, and I have a problem with that assumption.
I tried to clarify this in my first reply. You should interpret it as saying that stocks were massively undervalued and shouldn’t have gone up significantly more than bonds. I was trying to explain and didn’t want to include too many caveats, instead leaving them for the replies.
It’s interesting to note that several other replies gave the simplistic risk response without the caveat that risk can only explain a small minority of the premium.
>The vast majority of the equity premium is unexplained. When people say “just buy stocks and hold for a long period and you’ll make 10% a year”, they’re asserting that the unexplained equity premium will persist, and I have a problem with that assumption.
I completely agree with you here. My point is that this comment is different from the plain language interpretation of your top post. I know that is a seemingly small point, but I commented because I don’t want to leave future readers with the wrong impression. If we did not have this conversation, I think they may have been left thinking that it is a puzzle that stocks go up at all. I don’t view that as a simple caveat to the initial statement, but a different statement entirely.
Can we agree on the following statement? “While it is expected that stocks will go up, and go up more than bonds, it is yet to be explained why they have gone up so much more than bonds.”
The equity premium puzzle is still unsolved. The answer to your question is that nobody knows the answer. Stocks shouldn’t have gone up historically, none of our current theories are capable of explaining why stocks did go up. Equivalently, stocks were massively underpriced over the last century or so and nobody knows why.
If you don’t know why something was mispriced in the past, you should be very careful about asserting that it will or won’t continue to be mispriced in the future.
The classic answer is risk. Stocks are riskier than bonds, so they should be underpriced (and therefore have higher returns) than bonds.
But we know how risky stocks have been, historically. We can calculate how much higher a return that level of risk should lead to, under plausible risk tolerances. The equity premium puzzle is that the observed returns on stocks is significantly higher than this.
Read through the wikipedia page on the equity premium puzzle. It’s good.
Why shouldn’t have stocks gone up historically? Isn’t there more real wealth today than during the days of the East India Company? If a stock represents a piece of a businesses, and those businesses now have more real wealth today than 300 years ago, why shouldn’t stock returns be quite positive? To be honest I’m bewildered by this perspective that stocks should never go up—I’ve never seen anyone in finance academically or professionally entertain this idea, so I’m surprised to hear you say “no one knows the answer,” as if it’s a common puzzle in the field. Why some stocks go up more than others is a good and open question, but that’s one of relative valuation, not whether market returns on an absolute are greater than zero.
Start with https://en.wikipedia.org/wiki/Equity_premium_puzzle. There’s plenty of academic sources there.
People have grown accustomed to there being an equity premium to the extent that there’s a default assumption that it’ll just continue forever despite nobody knowing why it existed in the past.
>Isn’t there more real wealth today than during the days of the East India Company? If a stock represents a piece of a businesses, and those businesses now have more real wealth today than 300 years ago, why shouldn’t stock returns be quite positive?
I simplified a bit above. What’s unexplained is the excess return of stocks over risk-free bonds. When there’s more real wealth in the future, the risk free rate is higher. Stock returns would end up slightly above the risk-free rate because they’re riskier. The puzzle is that stock returns are way, way higher than the risk-free rate and this isn’t plausibly explained by their riskiness.
The equity risk premium puzzle is about a very different question, no? The equity premium puzzle is a puzzle because of how large the equity premium is to bonds, but it is totally expected that there is an equity premium or that bond and equity returns are positive. Concretely, the puzzle asks, why do equities earn 8% if the risk-free rate is 2%, instead of 3%? The puzzle is that 6% spread is much larger than what standard financial theory predicts (although a lot of the dispute ends up being around the right parameterization and benchmarks). But standard financial does predict (a) an equity premium to the risk-free rate and (b) positive returns for both equities and bonds.
I think you get to that understanding in your last sentence (“stock returns are way, way higher than the risk-free rate”), but this is a much different statement than “stocks shouldn’t have gone up historically” or “people have grown accustomed to there being an equity premium to the extent that there’s a default assumption that it’ll just continue forever despite nobody knowing why it existed in the past.” I don’t want to be a pedant, but those are much different statements, because they state that the absolute return on stocks should be 0, and that the positive return of equities is some puzzle. Maybe I’m misunderstanding you, but the straightforward interpretation of what you were saying is quite bold, and not something I’ve heard of before or have seen on wikipedia (including what you linked).
The vast majority of the equity premium is unexplained. When people say “just buy stocks and hold for a long period and you’ll make 10% a year”, they’re asserting that the unexplained equity premium will persist, and I have a problem with that assumption.
I tried to clarify this in my first reply. You should interpret it as saying that stocks were massively undervalued and shouldn’t have gone up significantly more than bonds. I was trying to explain and didn’t want to include too many caveats, instead leaving them for the replies.
It’s interesting to note that several other replies gave the simplistic risk response without the caveat that risk can only explain a small minority of the premium.
>The vast majority of the equity premium is unexplained. When people say “just buy stocks and hold for a long period and you’ll make 10% a year”, they’re asserting that the unexplained equity premium will persist, and I have a problem with that assumption.
I completely agree with you here. My point is that this comment is different from the plain language interpretation of your top post. I know that is a seemingly small point, but I commented because I don’t want to leave future readers with the wrong impression. If we did not have this conversation, I think they may have been left thinking that it is a puzzle that stocks go up at all. I don’t view that as a simple caveat to the initial statement, but a different statement entirely.
Can we agree on the following statement? “While it is expected that stocks will go up, and go up more than bonds, it is yet to be explained why they have gone up so much more than bonds.”
Did you see my initial reply at https://www.lesswrong.com/posts/4vcTYhA2X99aGaGHG/why-do-stocks-go-up?commentId=wBEnBKqqB7TRXya8N which was left before you replied to me at all? I thought that added sufficient caveats.
>”While it is expected that stocks will go up, and go up more than bonds, it is yet to be explained why they have gone up so much more than bonds.”
Yeah, I’d emphasize slightly more in expectation.