The equity premium puzzle

What this book actually teaches

The Equity Premium Puzzle (2008) by Rajnish Mehra is an academic monograph published by Now Publishers in the Foundations and Trends in Finance series. Mehra, a finance professor at the University of California Santa Barbara, is one of the authors of the original 1985 paper with Edward Prescott that named and defined the equity premium puzzle — a fundamental challenge to standard asset pricing theory. This book-length treatment expands on that foundational work and surveys the subsequent three decades of research that attempted to resolve, explain, or dismiss the puzzle.

The puzzle itself is this: the historical return premium of equities over risk-free assets (U.S. Treasury bills) has been approximately six to seven percentage points per year over the twentieth century in the United States. Standard consumption-based asset pricing models, calibrated to observed levels of risk aversion and consumption volatility, cannot generate a premium of that magnitude. To match the data using standard models, investors would need to be implausibly risk-averse — levels of risk aversion that would imply other observable behaviors that economists do not actually see. The gap between what theory predicts and what the data shows is the puzzle.

Mehra surveys the major proposed resolutions across three categories. The first involves modifying the preference structure: habit formation models (which make risk aversion countercyclically higher during bad times), recursive utility specifications, and models with ambiguity aversion have each been offered as ways to generate higher equity premiums within a coherent theoretical framework. The second category involves modifying the asset structure: introducing borrowing constraints, transaction costs, or limited market participation can reduce the risk-free rate and raise the equity premium separately, closing the gap through different channels. The third involves questioning the data: survivorship bias in the U.S. historical record (we're studying the twentieth century's most successful equity market), peso problems in rare disaster models, and measurement issues in consumption data all qualify what the historical premium actually represents.

The book is technical. Mehra writes for an audience of financial economists and doctoral students in finance and economics — the mathematical notation is standard for the field and is not simplified for a general reader. The Foundations and Trends format is explicitly a survey of academic literature rather than a book designed for application, and the book reads accordingly: calibration exercises, utility function specifications, and empirical methodology discussions occupy substantial sections.

The weaknesses for a practitioner audience are inherent in the genre. The equity premium puzzle is a research program, not a decision framework. Practitioners who want to understand whether the historical equity premium is likely to persist going forward will find this text illuminating on the theoretical question but not directly actionable. The survey is also now somewhat dated — the rare disaster literature and long-run risk models have continued developing after 2008.

For financial economists, doctoral students in finance or economics, and sophisticated practitioners who want to understand the theoretical foundations of the equity risk premium debate, this is the authoritative survey of the puzzle's origins and the research program it generated.

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About Rajnish Mehra

Read more from Rajnish Mehra and explore the full bibliography on ClearValue Books.