Equity premium puzzle or faulty economic modelling?
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Equity premium puzzle or faulty economic modelling? Abootaleb Shirvani1 · Stoyan V. Stoyanov2 · Frank J. Fabozzi3 · Svetlozar T. Rachev1
© Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract In this paper we revisit the equity premium puzzle reported in 1985 by Mehra and Prescott. We show that the large equity premium that they report can be explained by choosing a more appropriate distribution for the return data. We demonstrate that the high-risk aversion value observed by Mehra and Prescott may be attributable to the problem of fitting a proper distribution to the historical returns and partly caused by poorly fitting the tail of the return distribution. We describe a new distribution that better fits the return distribution and when used to describe historical returns can explain the large equity risk premium and thereby explains the puzzle. Keywords Rational finance · Equity premium puzzle · Normal compound inverse Gaussian distribution JEL Classification C10 · C13 · C18
1 Introduction An important measure in allocating funds among asset classes is the risk premium of an asset class (i.e., the spread between the return on the asset class and the risk-free interest rate). For this reason, there has been considerable research on the risk premium, particularly for equities. A study focusing on equities by Mehra and Prescott (1985) found that for the US for the period 1889–1978 there was an excessively large equity risk premium
* Frank J. Fabozzi [email protected] Abootaleb Shirvani [email protected] Stoyan V. Stoyanov [email protected] Svetlozar T. Rachev [email protected] 1
Department of Mathematics and Statistics, Texas Tech University, Lubbock, TX, USA
2
Charles Schwab Corporation, 101 Montgomery St., San Francisco, CA, USA
3
EDHEC Business School, Nice, France
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relative to what would be expected if investors’ behavior toward risk followed what was assumed by proponents of rational finance. That is, investors were much more risk-averse than traditional finance models assumed. This finding was referred to by Mehra and Prescott as the “equity premium puzzle”. The proponents of behavioral finance used the equity premium puzzle as an example of the limitations of rational finance. Benartzi and Thaler (1995), for example, suggested that “narrow framing” leads investors to overestimate equity risk and proposed an alternative to the standard investor preferences approach in Mehra and Prescott. They proposed the so-called myopic loss aversion model which is based on prospect theory, a theory based on experimental studies of human decisions under risk rather than relying on the assumption of purely rational market participants. Barberis and Huang (2006) extended this approach to an equilibrium framework to capture the equity premium, interest rate, and level of volatility observed in practice. Along these lines, behavioral finance proponents used ambiguity aversion (Chen and Epstein 2002; Barillas et al. 2009;
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