But if this were so, argue the critics, then the risk premium would virtually disappear and the return to equities would approximate to the return on bonds. So what's the problem, or should I say puzzle. There isn't one. The fault lies in the approach. The apparent paradox arises from the error of applying general equilibrium thinking to market processes, i.e., static analysis to a dynamic situation.
Bonds are simply fixed interest securities while equities are shares in companies.
Let us now look at the basic difference between them. Buying a bond is the equivalent of lending money at a fixed rate of interest. The bond itself is not an entitlement in the sense that equities are. Buying equities is the same as buying entitlements to capital goods employed by the firm that issued the shares. As the value of the company is the sum of discounted anticipated earnings, it is clear that the value of the share will vary with the anticipated earnings stream.