Sunday, September 7, 2008

Why does the equity premium puzzle literature seem to not consider this explanation?

Second in a series: My last post is the first.

My current goal is to do very little short-term-deadline related work so I can focus flexibly on long term (maybe very long term), high return learning, research, and business projects. I have a December 15th deadline to finish up some major work for the upcoming University of Arizona Personal Finance website, but after that it's just moderate teaching. I'm not taking on anything new with restrictive short term deadlines, maybe not for many years. I'm fortunate that I have the option to do this as an adjunct professor, and, to be honest, having done well in business and investing. Most professors don't have nearly so much flexibility to optimize, but I won't go off on the good and bad of academia now.

A big thing I want to work on is why I can't find in the literature my supply (of equity) related explanation for the equity premium puzzle. I've already looked over this literature pretty well, including Brad Delong and Konstantin Magin's recent survey article, but I will eventually be combing this literature with a fine tooth comb, and if I can't find anyone else offering an explanation like this, I will be developing it, and persistently asking why it's not offered until I get a reasonable answer.

In the meantime, though, I'll add this:

The vast majority of the literature seems to assume that the return of equity equals the return of a risk free fixed asset plus a risk premium. But I think this is a specification error. It's should really include a corporate efficiency or flexibility premium, which I haven't seen:

RE = RF + RiskPrem + EfficPrem

not

RE = RF + RiskPrem

And, as I explained in my last post, the efficiency comes from the fact that with stock the firm has greater flexibility to take large projects which may make little or no money for years, which may even lose money for years, but which overall will be very high return due to long run profits. There are many areas where short run constraints (often undue ones) greatly decrease optimization. This is true of business. It's true of politics, and it's also true of academia (unfortunately, very true.).

Warren Buffet, arguably the most successful investor in history, constantly attributes his success to unusual efforts and willingness to avoid short term constraints, so that he can choose the projects, within companies he controls, and in buying stock, that offer the highest NPV (Yes, my own personal situation was an inspiration for this explanation of the equity premium puzzle.) For example, in discussing his use of insurance company funds rather than debt to finance projects, he writes in his Berkshire Hathaway statement of business principles, "...they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt — an ability to have more assets working for us — but saddle us with none of its drawbacks."

All of the explanations for the equity premium puzzle I have seen in the literature are based on the demand side; trying to find utility functions for a representative investor, and ex-ante probability distributions for returns, that would explain investors demanding such high average returns for stocks relative to bonds, rather than bidding those returns down. But I suggest a supply side explanation (not to be confused with the academically discredited "supply side economics'"). The long run supply curve for corporate stock may simply be extremely long and flat, and consistently about 5 ½ percentage points in return higher than the premium bonds supply curve, even at stock quantities as high as the entire national savings rate.

Why would this be? As I've said, I posit that stock might simply allow a firm to create more wealth with an investment dollar than bonds. And this is because of the flexibility of stock. Firms are able to invest in high return long run projects when they raise money with stock that they sometimes cannot when money is raised from bonds due to the short run constraints of having to make interest payments and satisfy bond covenants. If my supply side hypothesis is true, or true to a large enough extent, then we could expect to continue to see stock returns outperform bond returns by large margins over the long run.

A big problem with the literature is that authors typically assume that the entire economy can be represented by just one representative agent. Then, they posit a utility function for that agent and calibrate it's parameters to empirical data. They are then "puzzled" that with the risk aversion parameters they find, or with any ones that look reasonable, the representative investor doesn't bid stock returns much lower, because they appear to have much too high an expected return relative to their risk.

I say the solution to this puzzle may be that there is not just one representative investor, but clienteles. Some people are just much more risk averse than average, and they will settle for a far lower expected return even to avoid moderate risk. Others have liquidity issues. They need a short term positive return guarantee badly, because, say, they are saving for their children's college education coming up in a few years, or they just need to know that they will have the cash necessary to pay monthly expenses.

Even if this clientele is very small (in investing dollars) relative to the much less risk averse clientele that doesn't mean that the much less risk averse clientele will bid down the equity return from its lofty level, because it depends on the supply of equity too. It's not just the demand for equity. If the demand is huge but the supply can keep up, even at high equity costs in terms of average return, then the average return will not fall.

And the supply curve could be that lofty, and persistently high and flat, or even increasing, due to the presence of a great deal of constant returns to scale, increasing returns to scale, and generally promising long term projects of the type that can't be carried out nearly as well with the short term constraints that come with fixed instrument financing. Please see the graph below:


Click graph to see a clearer full size version