Macroeconomic Perspectives on the Equity Premium Puzzle

Suppose you were born on January 1, 1983. A few months later, your parents, wanting to set aside some money for your 18th birthday, were at a crossroads. They could either invest money in risk-free Dutch government bonds or in the newly created AEX index, investing in companies’ shares. After careful consideration they decided to take a risk and invest (the equivalent of) e 100 in shares. On your 18th birthday your parents gave you an envelope and explained what they had done. When you opened the envelope you were flabbergasted to discover that this e 100 had grown to e 1.405,02; a staggering annual nominal return of slightly less than 16%. Inflation averaged at about 2%, so this translates into a real (i.e. corrected for inflation) return of 14%. But what would have happened if your parents had not taken a risk? Then the envelope would have contained e 260,01, a nominal and real return of 5.5% and 3.6%, respectively. This example illustrates that over longer periods, stocks provide an investor with a higher return than bonds. In economics this return difference is called the equity premium: the premium stocks pay over bonds.