7. The Equity Risk Premium and the Equity Premium Puzzle

All of finance rests on the proposition that investors dislike risk and demand higher returns as compensation for bearing risk. In behavioral terms, the equity risk premium may be regarded as the additional rate of return that risk-averse investors, as a class, demand in exchange for the burden of bearing volatility and the attendant risk of downside loss. Although one study has concluded that the replacement of standard deviation in the conventional CAPM by a downside risk measure would advise investors to lower the stock allocations within their portfolios,¹ another study suggests that investors’ reliance on fixed-income positions vastly exceeds the allocation that any strictly rational, utilitarian evaluation of risk in equity investing would ever counsel.² Given the presence of a “sizeable equity premium,” why indeed should “a substantial fraction of investable wealth [be] invested in fixed income instruments”?³