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Eureka: Equity Premium Puzzle
by Jay Gutman
2017-11-18 11:34:41
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A company can go viral but the government can't go viral. The equity premium puzzle is an economics puzzle where it is not clear why stocks generate on average higher returns than bonds. The nature of the structure of stocks and bonds explains why stocks on average generate higher returns than bonds. But first we need quick definitions on what stocks are and what bonds are.

equ01_400Companies have different sources of collecting money. They can use the CEOs money, which is what is done in a lot of countries. The CEO invests his savings into the company. Then there are loans, where businesses can go to private banks or investment banks and get loans that they will have to repay. Then there's listing the company on the stock market, where the company collects shares, several people chip in to buy shares, which the company returns once the profits set in. As for bonds, when the government needs to finance public projects, be it roads, bridges or public companies, it issues bonds where it collects money from speculators and returns the money once profits, i.e. taxes and public enterprise profits are collected.

Why do stocks have on average higher rates of return than bonds? The nature of the profits explains why it is so. If stocks go up, bonds go up. Bonds can't go up if stocks don' go up. That is, if stock prices go up, bond prices tend to go up because more taxes are generated from the profits. If the stock market crashes, bond prices tend to crash. That is bonds follow stocks and not the other way around.

Let's put it this way. If I work at a company I get a salary in exchange for work. The salary tends to have little flexibility and tends not to depend on the company's profits. If the company makes profits, the salary might go up a little. But if profits are declining, I might lose the job and get no salary at all. Now imagine most companies are making profits and paying stock dividends. It is likely that the government will get more taxes, thus returns on bonds might go a little up, but there tends to be a cap on how much taxes companies pay. If the stock market is not doing so well, unfortunately companies that go out of business don't pay taxes. So if a company makes 100% in profits, the government might get 50% of that or less. But if a company goes out of business, the government gets 0 in taxes. So either way the bonds will not excede average stock returns.

Let's put it this way. If stocks get N+1 the government gets N. If stocks get N+2 the government gets N+1. So the government is always getting N-1. Unless the government taxes over 100%, in which case the government would get N+1 but businesses would be losing money rather than making money. But it's a bit more sensitive than that. If taxes are over 50%, that means half the profits would go to the government where bonds would average higher returns than stocks, assuming that stocks perform well. If the government charges less than 50% on profits, bonds can't go higher than stocks. That's assuming that most stock-listed companies are doing well. Unfortunately many stock-listed companies actually lose money. Let's keep it short for the day.

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