Extrapolative Expectations and the Equity Premium

Abstract

Many stockholders irrationally believe that high recent stock market returns predict high future stock market returns. The presence of these extrapolators can help resolve the equity premium puzzle if the elasticity of intertemporal substitution (EIS) is greater than one. In our model, extrapolators’ overreaction to dividend news generates countercyclical expected returns while attenuating their consumption response. The equity premium is high because extrapolators believe stocks are a bad hedge and rational investors’ limited risk-bearing capacity prevents them from fully compensating for extrapolators’ reluctance to hold stocks. We match the U.S. data with a relative risk aversion of 4 and an EIS of 2.

Keywords: equity premium puzzle, riskfree rate puzzle, equity volatility puzzle, noise traders, irrational expectations, adaptive expectations, heterogeneous agents, elasticity of intertemporal substitution

JEL Classification: D51, E44, G12