Editing Equity premium puzzle (section)

== Implications ==

'''Implications for the Individual Investor'''

For the individual investor, the equity premium may represent a reasonable reward for taking on the risk of buying shares such that they base their decisions to allocate assets to shares or bonds depending on how risk tolerant or risk averse they are.<ref name="Anomalies: The Equity Premium Puzzl"/> On the other hand, if the investor believes that the equity premium arise from mistakes and fears, they would capitalize on that fear and mistake and invest considerable portions of their assets in shares. Here, it is prudent to note that economists more commonly allocate significant portions of their asset in shares.<ref name="Anomalies: The Equity Premium Puzzl"/>

Currently, the equity premium is estimated to be 3%. Although this is lower than historical rates, it is still significantly more advantageous than bonds for investors investing in their retirements funds and other long-term funds.<ref name="Anomalies: The Equity Premium Puzzl"/>

The magnitude of the equity premium brings about substantial implications for policy, welfare and also resource allocation.

'''Policy and Welfare Implications'''

Campbell and Cochrane (1995) have found in a study of a model that simulates equity premium value's consistent with asset prices, welfare costs are similar in magnitude to welfare benefits.<ref>{{cite journal |last1=Campbell |first1=John |last2=Cochrane |first2=John |title=By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior |journal=Journal of Political Economy |date=April 1999 |volume=107 |issue=2 |pages=205–251 |doi=10.1086/250059|s2cid=18750189 |url=http://nrs.harvard.edu/urn-3:HUL.InstRepos:3119444 }}</ref> Therefore essentially, a large risk premium in society where asset prices are a reflection of consumer preferences, implies that the cost of welfare is also large. It also means that in recessions, welfare costs are excessive regardless of aggregate consumption. As the equity premium rises, recession-state income marginal values steadily increase also thus further increasing the welfare costs of recessions. This also brings about questions regarding the need for microeconomic policies that operate by way of higher productivity in the long run by trading off short-term pain in the form of adjustment costs. Given the impact on welfare through recessions and the large equity premium, it is evident that these short-term trade offs as a result of economic policy are likely not ideal, and would be preferred to take place in times of normal economic activity.<ref name="ageconsearch.umn.edu"/>

'''Resource Allocation'''

When there is a large risk premium associated with equity, there is a high cost of systematic risk in returns. One of these being its potential implications on individual portfolio decisions. Some research has argued that high rates of return are just signs of misplaced risk-aversion in which investors are able to earn high returns with little risk from switching from stocks to other assets such as bonds.<ref name="ageconsearch.umn.edu"/> Research on the contrary indicates that a large percentage of the general public believe that the stock market is best for investors that are in it for the long haul<ref>{{cite book |last1=Shiller |first1=Robert |title=Irrational Exuberance |date=16 August 2016 |publisher=Princeton University Press |edition=3}}</ref> and may also link to another implication being trends in the equity premium. Some claims have been made that the equity premium has declined over time in the past few years <ref>{{cite journal |last1=Jagannathan |first1=Ravi |last2=McGrattan |first2=Ellen |last3=Scherbina |first3=Anna |title=The Declining U.S. Equity Premium |journal=Quarterly Review |publisher=Federal Reserve Bank of Mineneapolis|date=2001 |volume=24 |issue=4 |pages=3–19 |doi=10.21034/qr.2441|doi-access=free }}</ref> and may be supported by other studies claiming that tax declines may also continue to reduce the premium <ref>{{cite report |last1=McGrattan |first1=Ellen |last2=Prescott |first2=Edward |title=Taxes, Regulations, and Asset Prices |date=December 2001 |doi=10.3386/w8623 |doi-access=free }}</ref> and the fact that transaction costs in securities markets decline this is consistent with a declining premium.<ref name="ageconsearch.umn.edu"/> The trend implication is also supported by models such as 'noise traders' that create a cyclical premium due to noise traders being excessively optimistic thus declining the premium, and vice versa when the optimism is replaced with pessimism, this would explain the constant decline of equity premium as a stock price bubble.<ref name="ageconsearch.umn.edu"/>