After years of mathematical finance I am still not satisfied with the idea of a risk premium in the case of stocks.
I agree that (often) there is a premium for long dated bonds, illiquid bonds or bonds with credit risk (which in fact they all have). I can explain this to my grandmother. My question is very much in the vein of this one. Yes, investors want to earn more than risk free but do they always get it? Or does the risk premium just fill the gap - sometimes positive sometimes negative? Finally: Do you know any really good publications where equity risk premium is explained and made plausible in the case of stocks? Does it make any sense to say "with $x\%$ volatility I expect a premium of $y\%$"? Sometimes stocks are just falling and there is risk and no premium. What do you think?
Answer
If you have the mathematical sophistication, you should review the original papers referenced on the Equity Premium Puzzle page, particularly Mehra and Prescott (1985). Note, however, that contrary to other opinions on this page, the puzzle is NOT that there is an equity risk premium. On the contrary, the puzzle is that the premium had been so high, at least empirically up to the point in time those papers were written. More recently, it has been in vogue to claim that the risk premium has recently been too low, or perhaps even nonexistent. Some also question whether there is a monotonic relationship between risk and reward in the markets (see, e.g., low volatility anomaly). But no serious thinker believes there should be no risk premium at all.
The explanation you can "tell your grandmother" is that all stocks are issued by companies to raise money. Since companies fail a lot more often than governments, particularly governments such as the US that can control their own currency, they must at least promise to investors to pay them more than what they can get "risk-free" from the government. In practice, of course, some companies will fail, and sometimes entire economies will "fail" in the sense of underperforming expectations, and actual returns to investors may not match what was promised. That does not change the fact that what was promised is always greater than what could be gotten "risk-free" from a large, stable government. That is the equity risk premium.
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