If you are trying to understand the equity premium puzzle, then you have to understand what I mean by “equity premium”. Now that you know this, then you can start to think about it.
To start with, equity premium is the difference between the interest you pay and what you earn. The interest you pay is what you pay your bank when you open a new account. In a normal savings account it is what you pay a bank when you put your money in. The interest you pay is the interest you pay the bank. If you are making a loan, then you are paying the lender interest.
In any savings account, you pay a bank interest and then use that money to buy something. In a savings account with equity premium, you own stock and that is what you pay your bank when they lend you money.
I’m sure you’ve heard the term equity premium a million times, but what does it mean? It means you own shares of stock in your mutual fund. You pay a small fee, but after the money is in your account, money is loaned to you, and you can get interest if you are willing to pay a fee. In a normal savings account the bank lends you money, and you pay them interest, which is the amount you are paying them when you open your account.
In an equity premium account, the bank makes money by investing in the mutual fund. However, rather than lending money directly to you, the bank sells you shares of stock in their mutual fund. When you do your taxes, you pay the tax on your savings account, but your shares are not taxed. That means you pay no tax on your share of the fund, and the fund pays you a small profit on the money you loaned them.
Equity premium accounts are a bit like mortgage-backed securities (MBS), except you actually own the shares of the fund instead of the bank. The concept is that the bank will make money off you in the future, but the money you lend to them is not taxable until you decide to sell them. It’s a bit like a stock that you own directly.
You can either get a high-yield investment account, or a low-interest savings account. But if you have a high-yield account, your bank will make you pay a higher interest rate, unless the bank can convince you that you need the extra money. A low-interest savings account, on the other hand, is a money-market account, so no interest will be charged.
So why buy a low-interest savings account? Because if you do, your bank will make you pay a higher interest than you would if you were to invest directly in stocks. As long as your savings account is earning a decent return (at least 2% a year), the bank will make you pay a higher interest rate because you have to pay more for the same amount.
The equity premium puzzle is a little tricky to solve. I recommend starting with a lower interest rate because if you overinvest into stocks, you’ll end up with a lot of money that you won’t need. So the lower the rate you find, the less you need to start with.
