Investment psychology
The Equity Risk Premium puzzle
This post delves into the question of whether the conventional wisdom about the riskiness of stocks vis-a-vis bonds is wrong. Over many decades of investing in stocks, and occasionally bonds, I have come to think that stocks are less risky than bonds when you take returns and inflation into account.
My first experience with the riskiness of stocks was in the early 1970s when the Nifty Fifty stock bubble broke. I invested through the stock crash on October 1987 when the market dropped 22.6% in a single day, the bursting of the Dot Com bubble and the Great Financial Crisis. Many readers will know that my default asset allocation is 100% stocks.
My first experience with the riskiness of bonds was in the late 1970s, acting as lawyer for a large group of retired police officers whose fixed income pensions had been decimated by inflation. Bond values crashed in the 1970s resulting in massive capital losses. From the perspective of 2025, a significant erosion of bond values occurred recently with a spurt in inflation. In fact, real bonds values are constantly being eroded even if inflation is at Fed target of 2%. It may not feel like it but a true Money Illusion (look it up) takes place. Each year the real capital value of a bond is eroded by 2% or whatever the inflation rate is.
The riskiness of stocks vis-a-vis bonds is priced by the stock market. The idea that you enjoy a premium return investing in stocks is a reflection of the common-sense idea that higher risk needs a higher reward. But, risk is in the eye of the beholder. The premium return from stocks reflects investor risk aversion, information uncertainty and perceptions of macroeconomic risk. In the world of finance, it’s called the Equity Risk Premium.
One of the worlds leading experts on the Equity Risk Premium is Aswath Damodaran. He is a professor of finance at the Stern School of Business at New York University. His area of focus is corporate finance and equity valuation. He has been described as the world’s foremost expert on the subject of corporate valuation. He regularly publishes an updated paper on the Equity Risk Premium. The latest weighs in at 155 pages. Equity Risk Premiums (ERP): Determinants, Estimation, and Implications – The 2024 Edition by Aswath Damodaran :: SSRN
The following chart depicts the Equity Risk Premium in blue over the last 12 months. In January 2025 the Equity Risk Premium stood at 4.33%. That is, equity investors (S&P 500) could expect a return of 4.33% over the so called ‘risk free’ ten-year treasury bonds. You would need to read 155 pages to understand how all this is calculated. What these numbers suggest is that the stock market in January 2025 was pricing the riskiness of stocks vis-a-vis bonds with a premium of 4.33%
And, as Professor Damodaran explains, this premium reflects investor risk aversion, information uncertainty and perceptions of macroeconomic risk. Now, of course, investor risk aversion can fluctuate, as can uncertainty and macroeconomic risk. So the Equity Risk Premium fluctuates.
The Equity Risk Premium Puzzle
But, the Equity Risk Premium of stocks is too high! It is too large based on the most reasonable assumptions. It always has been and looks like it always will be.
Damodaran cites with approval research by Mehra, Rajnish, and Edward C. Prescott, 1985, The Equity Premium: A Puzzle, Journal of Monetary Economics, v15, 145–61. The researchers concluded that investors would need implausibly high risk-aversion coefficients to demand the premiums they identified.
Researchers have been looking for years to provide explanations for this puzzle. Explanations include ideas like: looking at U.S. data is biased upwards; observed volatility in an equity market does not fully capture the potential volatility; a declining marginal tax rate; small changes in consumption can cause big changes in marginal utility; short-term investors demand a higher risk premium; investors who receive constant updates on equity values; and, propensity of markets to overreact.
Damodaran’s conclusion is that “it is not quite clear what to make of the equity risk premium puzzle. It is true that historical risk premiums are higher than could be justified using conventional utility models for wealth.”
There is one explanation that makes sense to me. It is derived from behavioral psychology. It is called a cognitive error. The specific cognitive error we are concerned with here is that Humans tend to miss-weight high probabilities of gains by risk aversion. They do this through consistent overweighting of improbable outcomes.
To explain this, I will cut and paste some paragraphs from my December 22, 2024 post. I invite readers cycle back after you read this current post and read the December post to make the present discussion come crystal clear.
Prospect Theory
Kahneman says: “Our theory was closely modeled on utility theory but departed from it in fundamental ways. Most important, our model was purely descriptive, and its goal was to document and explain systematic violations of the axioms of rationality in choices between gambles.” (Kahneman, Thinking, Fast and Slow 2011) p271 (Emphasis added)
Critical to understanding all this is the definitions of the expressions risk seeking and risk averse.
By Kahneman’s definition, risk aversion does not have the hazy meaning of somehow not liking to take risks. Risk aversion is specifically an unwillingness to take on a risk in spite of the fact that the reward amply justifies the risk taken. That is, the gamble or investment has a positive ‘expected value’.
Warren Buffett explained ‘expected value’ at the Berkshire Hathaway Annual Meeting in 1989: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.”
Similarly, risk seeking has a specific meaning. Risk seeking is taking on a risk in spite of the reward not justifying the risk taken. That is, the gamble has a negative expected value.
Both risk averse and risk seeking behavior can almost be thought of as pathological, although tails wagging dogs sort of sums it up.
Fourfold pattern
Kahneman and Tversky’s work identified four situations in which human decision makers are likely to overweight an improbable outcome.
Kahneman tells us: “The fourfold pattern of preferences is considered one of the core achievements of prospect theory. (Kahneman, 2011) p317 (Emphasis added)
Miss-weight high probabilities of gains by risk aversion
Kahneman illustrates this one by two sets of choices.
(A) 61% chance to win $520,000 or a 63% chance to win $500,000
(B) 98% chance to win $520,000 or a 100% chance to win $500,000
Kahneman writes: “If you are like most people, you preferred the left-hand option in problem A and you preferred the right-hand option in problem B. If these were your preferences; You have just committed a logical sin and violated the rule of rational choice.” Kahneman, 2011) p313
This is the certainty effect. Outcomes that are almost certain, but are not completely certain, are given less weight than their probability justifies. As Humans, we are cognitively biased to certain compared to almost certain. We are biased to “Risk Free” compared to the S&P 500. That is, the Equity Risk Premium of stocks is too high based on the most reasonable assumptions.
Conclusion
Stocks are not risk free. My point simply is that investors miss-weight the relative riskiness of stocks vs bonds because of the perceived certainty of bonds and fear of disappointment in stocks. This is the certainty effect. Outcomes that are almost certain but are not completely certain (stocks), are given less weight than their probability justifies. We are biased to certain compared to almost certain.
This is good news for serious stock investors. The price of risk is really too high. That is, Mr. Market demands a very high expected return before he will invest in stocks, making expected returns relatively higher for astute investors. Whereas Mr. Bond suffers money illusion.
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For readers wishing to dig a little deeper into investment psychology, the following post offers a gateway:
Investment psychology explainer for Mr. Market – introduction
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