The Equity Premium Puzzle

Edward Prescott, Rajnish Mehra

Research

17 Pages

This paper examines why the historical return advantage of U.S. stocks over relatively riskless securities is far larger than standard economic models can explain. Using data from 1889 to 1978, the authors find a 6.18% average equity premium that conventional assumptions struggle to justify.

Key Takeaways

Premium Defies Models: From 1889 to 1978, equities returned 6.98% annually in real terms versus 0.80% for relatively riskless securities.
Risk Aversion Falls Short: With risk aversion below 10, the model generates a maximum equity premium of roughly 0.35%, far below the historical 6.18%.
Consumption Looks Stable: Real per capita consumption grew 1.83% annually with a 3.57% standard deviation, making observed equity returns difficult to reconcile with consumption risk.
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