Equity Premium Puzzle or Faulty Economic Modelling?
Abootaleb Shirvani, Stoyan V. Stoyanov, Frank J. Fabozzi, and, Svetlozar T. Rachev
TL;DR
This paper argues that the equity premium puzzle can be explained by selecting a more suitable return distribution, challenging previous interpretations of high risk aversion and highlighting the importance of proper statistical modeling.
Contribution
It introduces a new distribution for return data that better fits historical returns, providing an alternative explanation for the equity premium puzzle.
Findings
A new distribution fits historical return data more accurately.
Proper distribution choice can explain the large equity risk premium.
The high risk aversion observed may be due to distribution fitting issues.
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.
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