Financial mystery solved: the end of the equity premium puzzle

03 January 2006

A leading researcher at UNSW has solved one of the most enduring mysteries of the world's financial markets, a result which could revolutionise the way we invest.

UNSW Professor Peter Swan, from the School of Banking and Finance in the Faculty of Commerce & Economics, has uncovered why equity investments, such as shares and units in managed funds, on average outperform the bond market by between six and eight percent per annum. This is known as the 'equity premium puzzle'.

The research has been presented to the top business schools in the United States, including the University of Chicago, Northwestern, Carnegie Mellon, Vanderbilt, UC Santa Barbara, as well as the Singapore Management University and Nanyang Technological University.

As part of his landmark research, Scientia Professor Swan who is an ARC Australian Professorial Fellow, has developed a mathematical model that could be used to earn higher returns.

"My model can help identify illiquid equities, that is, those that do not trade very often, that have the right trading characteristics," said Professor Swan. "This is important because those stocks that investors want to trade but choose not to because of trading frictions, such as high transaction costs, are likely to command higher returns. If you don't want to trade much then you may be better off with such a portfolio. In fact, to assist, the Australian Stock Exchange (ASX) ought to offer indexes based entirely on liquidity/illiquidity."

The model that Professor Swan developed incorporates the benefits and costs of trading equity investments and bonds, in determining returns. It simulates how equity and bond markets have operated in the past 50 to 100 years.

"People think that the higher returns we've seen on the stock market are due to risk, but that only explains about half a percentage point of the higher returns enjoyed by equity, as shown by previous research (Mehra and Prescott)," said Professor Swan.

"In my theory, the remaining 5.5 percent to 7.5 percent represents compensation for lack of liquidity," he said.

Professor Swan's work helps to account for the theory of "irrational exuberance", a term coined by the US Federal Reserve chairman, Alan Greenspan. It refers to large price fluctuations for stocks.

"Until now, no-one had provided a theory for why stock prices are so volatile when dividends are stable and earnings are relatively stable," said Professor Swan. "The biggest benefit of all is from trading that security. That benefit can vary dramatically on a day-to-day basis. Every time someone trades the security that is associated with volatility in the returns and price of the stock. We no longer need the new field of 'behavioural' finance to explain 'excess' volatility."

Contact details: Susi Hamilton, UNSW Media unit, tel. 9385 1583 or 0422 934 024, email susi.hamilton@unsw.edu.au