The equity premium puzzle (EPP) has perplexed economists and investors for decades. In 2025, with Australia’s financial landscape more dynamic than ever, understanding why shares keep outperforming bonds is essential for anyone building wealth. Let’s decode the EPP, explore fresh research, and translate the findings into practical investing insights for Australians today.
What is the Equity Premium Puzzle?
The equity premium puzzle refers to the historical observation that shares (equities) have delivered much higher returns than government bonds—far more than traditional economic models can explain. Since the 1980s, researchers like Rajnish Mehra and Edward Prescott have pointed out that the average return gap, or ‘equity risk premium,’ should be much lower if investors were truly risk-averse in line with standard theories.
To put it simply, if owning shares is riskier, investors should only demand a modest premium over safe bonds. But in reality, the premium has been surprisingly large. In Australia, the average annual equity premium (shares minus government bonds) since the 1980s has hovered around 5–6%—a figure that challenges classic economic logic.
- Australian shares: Average annual return ~9–10% (long-term)
- Australian government bonds: Average annual return ~3–4%
This persistent difference is the essence of the puzzle: why don’t more people pile into shares, pushing the premium down?
Fresh Thinking: 2025 Insights and New Theories
Economists have thrown everything at the EPP—risk aversion, behavioural quirks, rare economic disasters, and market frictions. In 2025, several fresh perspectives are in the spotlight, especially as Australian investors face volatile markets, shifting interest rates, and policy reforms.
Behavioural Economics Takes Centre Stage
Recent research highlights the role of loss aversion—the idea that people fear losses more than they value gains. Aussies, like investors worldwide, may avoid shares not because the returns aren’t attractive, but because the pain of occasional downturns looms large in their decision-making. This emotional factor helps explain why many still prefer the relative safety of bonds or term deposits, even as they sacrifice long-term growth.
Market Access and Participation Gaps
Not everyone has equal access to share markets. Barriers—such as limited financial literacy, high minimum investment thresholds, and lack of trust—keep many Australians underinvested in equities. According to ASIC data from 2024, only around 37% of adult Australians directly own shares outside of superannuation. Policy pushes like the federal government’s new ‘Financial Inclusion Strategy 2025’ aim to close this gap, but it remains a major factor in sustaining the equity premium.
Structural Changes: The Rise of Super and ETFs
Australia’s compulsory superannuation system and the explosion of low-fee ETFs have broadened share ownership. Yet, even with more Aussies exposed to equities via their super, risk aversion and inertia mean many still allocate conservatively. The 2025 Productivity Commission review found that the average balanced super fund has only about 60% in growth assets (shares and property), with the rest in defensive assets like bonds.
What Does the Equity Premium Puzzle Mean for Investors in 2025?
For Australians planning their financial future, the EPP isn’t just academic trivia—it’s a crucial signal about where long-term wealth is built.
- Long-term outperformance: Shares have consistently outpaced bonds, rewarding those who can stomach volatility.
- Risk and reward: The premium persists because not everyone is willing or able to take on the emotional rollercoaster of equity markets.
- Policy implications: Government initiatives like the ‘Financial Inclusion Strategy 2025’ and super reforms are slowly nudging more Australians into equities—but the puzzle endures.
Real-world example: Consider two investors starting in 1995, each with $50,000. One puts it in a diversified Australian shares ETF, the other in 10-year government bonds. By 2025, the shares investor would have seen their wealth multiply around fivefold, while the bond investor might only double their money. The difference is the equity premium in action.
Where to From Here? Navigating the Puzzle in Your Portfolio
Understanding the EPP can help Australians:
- Rethink their risk tolerance: Consider whether fear of losses is holding back your long-term goals.
- Review super allocations: Make sure your mix of growth and defensive assets suits your time horizon and appetite for volatility.
- Take advantage of policy shifts: New government initiatives may lower barriers and costs for equity investing in 2025.
While no-one can predict the future, history suggests that the equity premium isn’t vanishing anytime soon. For Australians willing to ride out the bumps, shares remain a powerful engine for building wealth.
