Friday, July 17, 2009

The Equity Risk Premium: "Using Garbage to Measure Consumption"

From the WSJ's Real Time Economics:
To solve the so-called equity premium puzzle, one researcher has gone digging through the garbage.

In a forthcoming paper in the Journal of Finance titled “Asset Pricing with Garbage,” University of Chicago graduate student Alexi Savov makes the case that the amount of rubbish we produce is a better (i.e. more volatile) measure of consumption than traditional tools, and that helps explain why investors demand such a high premium for stocks over bonds. (That’s government bonds, not “junk” bonds, of course.)

The equity premium puzzle has been festering unsolved in economic circles since the 1980s. The puzzle is this: economists can’t adequately explain why investors demand such high-risk premiums to own volatile stocks over relatively steady bonds. The risk premium for stocks over bonds in the long term is about 6%. But 6% seems like too big a premium to economists.

In theory, one way to explain the premium would be to look at consumption, a broad measure of wealth. People should demand a premium from an investment that goes down when consumption goes down. That’s because the alternative — bonds — hold on to their value when consumption declines. Another way to put it: When you are making lots of garbage, you are rich. When you stop making garbage, you are poor. Unlike bonds, which continue to pay out whether you produce lots of garbage (and are rich) or not, stocks are likely to lose their value during bad times. Therefore, investors should want a large reward for putting their money in something whose value decreases at the same time as their overall wealth decreases....MORE