Subjective Expectations and Asset-Return Puzzles
Weitzman, Martin L. 2007. "Subjective Expectations and Asset-Return Puzzles."
American Economic Review,
In textbook expositions of the equity-premium, riskfree-rate and equity-volatility
puzzles, agents are sure of the economy's structure while growth rates are normally
distributed. But because of parameter uncertainty the thin-tailed normal
distribution conditioned on realized data becomes a thick-tailed Student-t distribution,
which changes the entire nature of what is considered "puzzling" by reversing
every inequality discrepancy needing to be explained. This paper shows that
Bayesian updating of unknown structural parameters inevitably adds a permanent
effect to posterior expectations. The expected-utility ramifications of
this for asset pricing are strong, work against the puzzles, and are very sensitive to
subjective prior beliefs—even with asymptotically infinite data. (JEL D84, G12)
Article Full-Text Access
Weitzman, Martin L.