equity premium puzzle: a standalone construct

Rajnish Mehra and Edward Prescott's 1985 paper The equity premium: A puzzle named the problem: over roughly a century of United States data, the average return on stocks exceeded the return on safe short-term government debt by about six percentage points a year, a gap far larger than a standard consumption-based asset pricing model can justify unless investors are assumed to be implausibly averse to risk. In economics a premium of this kind is the extra return investors require for bearing risk, and the puzzle is that the observed size of the equity premium implies a level of risk aversion that conflicts with how households are seen to behave in other settings. Mehra and Prescott's 2003 retrospective, The equity premium in retrospect, restated the finding across additional countries and later data and reviewed the proposed resolutions, from habit formation and rare disasters to alternative preferences, none of which had settled the question. The construct is a landmark because it is a precise, replicable quantitative anomaly rather than a loose observation: it fixes a specific magnitude that any candidate model of asset prices and consumption must be able to reproduce.[1][2]

Unit

A quantitative anomaly measured in percentage points per year: the unexplained portion of the average return difference between equities and safe assets

Recovery means

Not applicable

Measured by

Operationalised by comparing long-run realised average returns on a broad stock index with those on short-term government debt, then testing whether a consumption-based asset pricing model with plausible risk aversion can reproduce the observed difference