Watch the Horizon
By Bryan Caplan
Check out Brad DeLong’s elegant explanation of the equity premium puzzle. If you look at the 1-year stock vs. bond return spread, it’s easy to see why people don’t buy more stocks. But if you look at the 20-year stock vs. bond return spread, it’s very hard to see:
[T]he reason that the large value of the equity risk premium is called a “puzzle” is that the marginal one-year investor is not the only possible marginal investor. Consider the marginal twenty-year investor: somebody 40 with ten-year-old children who is putting money away to spend on his or her children’s college, or somebody 50 saving for expenditures at 70 after they have retired. This marginal investor has to be satisfied with the configuration of asset returns as well. And what does the distribution of twenty-year-returns–either buy and hold a distributed portfolio of stocks (reinvesting the dividends) or buying and rolling over short-term Treasury bonds–look like? The answer is shown in Figure 2, which plots the twenty-year return differential over the twentieth century…
What kind of investor would turn up a 96% chance of gain, associated with an expected more-than-doubling of relative wealth, that carries with it only a 4% chance of any relative loss and a maximum loss of 17% of relative wealth? Where is this twenty-year marginal investor, and what is he or she possibly thinking? All such twenty-year marginal investors should be furiously pulling much more money out of short-term bills and investing it into diversified portfolios of stocks, thus making the equity risk premium lower and stocks less of an overwhelmingly attractive long-run investment. That is the equity premium puzzle.
Overall, I’m convinced that the puzzle is real, and invest accordingly. But sadly, a lot of economists who know better don’t.