Financial Daily from THE HINDU group of publications
Sunday, May 01, 2005
Financial Daily from THE HINDU group of publications Sunday, May 01, 2005 |
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Investment World
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Stock Markets Columns - Simple Economics Equity-premium B. Venkatesh
IF you had bought shares that constituted the S&P CNX Nifty index, your one-year return as of March 31, 2005 would have been 15 per cent. The returns are higher if you had invested for 3-5 years. Financial economists term such high returns as the equity-premium puzzle. What does this mean? Suppose you have Rs 10 lakh to buy stocks and bonds. Assume the bond market returns 5 per cent per annum. What will prompt you to buy stocks? You will need 5 per cent plus an additional return to compensate you for the higher risk, as stocks are riskier than bonds. This additional return is called the equity risk premium. If the stock market returns 20 per cent, the excess return of 15 percentage points over the bond market is the equity risk premium. But why is it called equity-premium puzzle? Financial economists argue that the risk premium is too high. Rajnish Mehra and Edward Prescott in their 1985 paper were the first to raise this issue. Dozens of papers have been published since then explaining the equity premium puzzle. The most practical explanation is provided by behavioural finance professionals. They argue that you and I fear that an event like May 17, 2004 could happen anytime in the stock market. That was the day when the Bombay Stock Exchange fell 800 points. That is, we are not concerned about the average risk of the stocks declining in the market. Instead, you and I worry about May 17-like extreme events. Statistically speaking, we are bothered about fat left tails. So, if you look at risk premium as reward for average risk, there is indeed a puzzle. Not so if risk premium is seen as a compensation for the extreme-event risk.
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