Can Kelly Gambling Explain Equity Risk Premia?
19 Pages Posted: 7 Jul 2020 Last revised: 24 Dec 2020
Date Written: December 22, 2020
Standard finance theory has long identified equity investment with aggregate consumption and equity investors with average consumers, while treating most growth risks as iid. The combination makes it impossible to reconcile high equity risk premia with low risk aversion. Reinterpreting equity markets as gambling casinos with unstable risks cuts a Gordian knot. Enrichment-seeking gamblers pursuing fractional Kelly strategies need a risk premium to maintain net long positions in equities. In simulations that use GDP disaster risks to proxy dividend trends, rational learning induces enough volatile excess volatility to account for risk premia of hundreds of basis points.
Keywords: risk premium, equity pricing, expected utility, constant relative risk aversion, disaster risks, Kelly criterion, fractional Kelly
JEL Classification: D11, G11, G12
Suggested Citation: Suggested Citation