The equity premium puzzle refers to the inability of an important class of economic models to explain the average equity risk premium (ERP) provided by a diversified portfolio of equities over that of government bonds, which has been observed for more than 100 years. There is a significant disparity between returns produced by stocks compared to returns produced by government treasury bills.[1] The equity premium puzzle addresses the difficulty in understanding and explaining this disparity.[1] This disparity is calculated using the equity risk premium:
The equity risk premium is equal to the difference between equity returns and returns from government bonds. It is equal to around 5% to 8% in the United States.[2]
The risk premium represents the compensation awarded to the equity holder for taking on a higher risk by investing in equities rather than government bonds.[1] However, the 5% to 8% premium is considered to be an implausibly high difference and the equity premium puzzle refers to the unexplained reasons driving this disparity.[3]