Chartered Alternative Investment Analyst (CAIA) Level I Practice Test

The equity premium puzzle refers to the observation that the average returns on equities have been significantly higher than what traditional financial theories, particularly models based on risk and utility, would predict. This discrepancy is particularly notable in the context of the long-term returns of U.S. equities versus those of risk-free assets, such as government bonds.

Investors expect to earn a risk premium for holding equities, which are inherently riskier than risk-free assets. However, the empirical evidence shows that the actual historical excess returns on equities above the risk-free rate are much greater than would be justified by the risk levels measured by traditional models. This leads to the puzzle: if investors are rational and the models are correct, why do they accept such lower expected returns from risk-free assets in comparison to the higher returns expected from equities?

This understanding helps highlight potential flaws in the assumptions behind conventional asset pricing models, such as the capital asset pricing model (CAPM), and has prompted further research into behavioral finance and alternative risk assessments. It underpins a significant area of discussion in finance regarding risk, return, and investor behavior.