The answer in a few words? The equity risk premium. We’ll be talking about this a little bit in class tomorrow, when we discuss the pricing of stocks. Meanwhile, here’s an excerpt:
…there is a not-easily-measurable number called the equity risk premium. Simply put, this premium is the extra return that stocks have to pay, because they’re riskier than safe government bonds, in order to attract investors. It’s the same reason that individual numbers on a roulette wheel pay more than odds or evens: higher risk, higher return.
For decades, the returns on stocks have usually been much higher, relative to bonds, than risk alone would seem to justify — perhaps as much as six or seven percentage points higher. If risk were the only explanation, the difference would suggest that investors were extremely risk-averse, to the point that they would never leave the house for fear of having to cross the street. [The NYT]
The handout is uploaded to the ‘Handouts’ section.
The author of the article goes on to cite a paper by Goetzmann and Ibbotson of Yale University. I’m uploading the paper to my server. If you’re the adventurous type, you can download it and take a shot at it [pdf].