8. The Equity Premium Puzzle

On average, equities historically deliver returns that exceed those on safe assets by several percentages every year. Over time and in nearly all developed economies, the equity risk premium is considerable. Yet puzzles persist. Despite that premium, why do so many potential investors avoid holding stocks? Stock market nonparticipation is a major contributory to social insecurity, particularly in the USA, where many aging households are financially unprepared for retirement. The equity premium puzzle consists of two parts. First, why are risk-free rates so low? Second, why do equities command a premium beyond the level that any realistic model of risk aversion would predict? The answer lies in habit formation over the course of the economic life-cycle. Unlike other components of aggregate wealth, human capital cannot be readily traded. Returns on human capital in the form of wages are peculiarly vulnerable to job loss during recessions and economic downturns. Maintaining an ever more comfortable lifestyle—catching up with the Joneses, so to speak—exposes households to macroeconomic risks that conventional asset pricing models do not fully reflect.