EFF: There never was one. The "puzzle" comes out of a simplified economic model that says the average spread of the equity market return over the t-bill return has been too high, given the risk of equities. It is easy to show that this argument is silly. Thus, the returns from equity investing are quite risky. As a result, if the high average stock return of the past is the true long-term expected return, the high volatility of stock returns nevertheless means that getting a positive equity premium (of any size) is highly likely only for holding periods of 35 years (an investment lifetime) or more. Given this result, the historical equity premium does not seem too high.
The simplified model that produces the equity premium puzzle, says that the premium (the difference between the expected returns on stocks and bills) should be about 1% per year (or even less). If the premium were this small, the required holding period to be relatively sure of getting a positive premium would be about 1600 years. Who would be willing to hold equity on these terms?
KRF: As an investor, I agree with Gene. I would not put much in the stock market if the expected equity premium were only 1%. That leaves the fascinating question (well, at least it's fascinating to me) of what is wrong with our models. They predict a low expected premium because measured consumption does not vary much with stock returns, which means that from an expected utility perspective stocks are not very risky.
Some researchers have tried to explain the puzzle by arguing that aggregate consumption is measured poorly. Others have tried to refine the models, to include, for example, differences in the tastes of investors, limits on borrowing, and risks associated with employment. I don't think any of these efforts has resolved the conflict.
Benartzi and Thaler offer a totally different solution in "Myopic Loss Aversion and the Equity Premium Puzzle" (Quarterly Journal of Economics, 1995). They argue that the problem is the expected utility framework, and suggest that the observed equity risk premium makes sense if we use the value function from Kahnman and Tversky's (1979) prospect theory to describe investor preferences. When I think about my own preferences, this argument seems reasonable to me.
Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.