In 1985, Rajnish Mehra and Edward C. Prescott, economists then at Columbia University and the University of Minnesota, published a paper pointing out a strange anomaly they dubbed “the equity premium puzzle.” Since the late 19th century, stock investments in America had generated returns that were 6 percent higher than what economists call “the risk-free rate—the yield on an investment for which there is virtually no risk of losing your principal. The low-risk investments, such as short-term U.S. government debt, had yielded less than 1 percent.Those “excess” stock-market returns, which include both price appreciation and dividends, are much higher than you would expect if they simply reflected the risk of losing your investment (don’t even get me started on the arcane procedures by which economists arrived at this conclusion). Moreover, this premium cannot simply be attributed to an underestimation of future corporate growth by investors. Even when expected dividend or corporate-earnings growth is taken into account, stock returns are higher than one would predict.
Mehra and Prescott’s paper coincided with the early stages of a long boom in equities that lasted from 1982 to 2000. In the years after its publication, people like Wharton’s Jeremy Siegel (and many less careful or measured imitators) wrote books touting the benefits of long-term stock investing. Americans jumped into the stock market, first tentatively, then eagerly, and finally almost hysterically. Convinced that equities offered an attractive risk-reward ratio, they began bidding up the price of stocks. Stock-price increases fueled expectations of further growth, until by 1999, a Securities Industry Association survey showed that investors expected to earn an annual rate of return of 30 percent. In other words, they expected that by 2010, stock prices would have skyrocketed.