The Nature of Market Growth, Risk and Return
Posted: 11 Nov 2002
In the model of asset appreciation advanced here, the market economy and the market of asset claims on the economy are modeled as organic (or exponential growth) processes, similar to those commonly seen in nature and the biological sciences. In "Dempsey's organic growth model of appreciation" (Dogma), investors have a log-wealth utility function. Within the framework, the market risk premium is derived as the premium that balances supply and demand across risky and risk-free assets. The model indicates that the premium is less than is indicated by ex-post returns observed on U.S. stock markets. The model is consistent, however, with empirical observations that idiosyncratic risk and small company size are rewarded by the markets. In terms of the model, investors choose to allocate their portfolios long in both the risky market and the risk-free asset. Furthermore, their portfolios are independent of the investment time horizon.
Keywords: the market risk premium, idiosyncratic risk, volatility, size effect, investment time horizon, exponential growth
JEL Classification: G1
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