The equity premium puzzle: High required equity premium, undervaluation and self fulfilling prophecy

TL;DR: In this paper, the authors argue that most market participants do not use standard theory (such as a standard representative consumer asset pricing model) for determining their required equity premium, but rather, they use historical data and advices from textbooks and finance professors.

Abstract: We argue that the equity premium puzzle may be explained by the fact that most market participants (equity investors, investment banks, analysts, companies?) do not use standard theory (such as a standard representative consumer asset pricing model) for determining their Required Equity Premium, but rather, they use historical data and advices from textbooks and finance professors. Consequently, ex-ante equity premia have been high, market prices have been consistently undervalued, and the ex-post risk premia has been also high. Professors use in class and in their textbooks high equity premia (average around 6%, range from 3 to 10%), and investors use higher equity premia for valuing companies (average around 6%). The overall result is that equity prices have been, on average, undervalued in the last decades and, consequently, the measured ex-post equity premium is also high. As most investors use historical data and textbook prescriptions to estimate the required and the expected equity premium, the undervaluation and the high ex-post risk premium are self fulfilling prophecies.