Discussion and Critical Review of the Equity Premium Puzzle

It is believed that Efficient Market Theory is based upon some fallacies and it does not provide strong grounds of whatever that it proposes. More importantly the Efficient Market theory is perceived to be too subjective in its definition and details and because of this it is close to impossible to accommodate this theory into a meaningful and explicit financial model that can actually assist investors in making the investment decisions (Andresso-O’Callaghan, B., 2007).

As Chapter 10 questions, if further evidence continues to surface that capital markets do not always behave in accordance with the efficient market hypothesis, then should we reject the research that has embraced the EMH as a fundamental assumption? In this regard we can return to earlier chapters of this book in which we emphasised that theories are abstractions of reality. Capital markets are made of individuals and as such it would not (or perhaps, should not) be surprising to find that the

According to Aswath Damodaran equity risk premium in the US in 1979 was 6.45%, thus

An investor would invest in a security for the return. However that return comes with a premium, the Risk. The higher the risk an investor is willing to take the higher the returns would

In regards to investing in stocks, bonds, currencies, or other investment products, it has always been a normal emotion to be happy when a stock price rose and upset when a stock price fell. Yet for Warren Buffet and his team at Berkshire they welcome these declining prices because of the opportunities it brings. According to Warren Buffet, a true investor would be buying stocks and businesses for their entire life, and “with these intentions, declining prices for businesses benefit us, and rising prices hurt us.” Understanding that the investor is going to be a buyer for eternity an investor should

The securities below the slope are overvalued stocks because for a given systematic risk the expectation is high . (Sharpe , 1964)

The risk premium is equal to the difference between the risk-free rate and the expected market return. The case study provides two historical equity risk premiums; the geometric and arithmetic mean. The conventional wisdom is that the geometric mean is considered a better estimate for valuation over long periods, while the arithmetic mean a better estimate for valuation over shorter periods. To coincide with the choice of the 20yr yield on U.S. Treasuries, the geometric mean was therefore chosen for this analysis i.e. (Rm-Rf) = 5.9%

The historic average returns from 1950 to 1996 and from 1929 to 1996 are given In Exhibit 3. We chose the latter time period as we considered it would give us a more reliable estimate of the risk-free rate by discounting both the Second World War and the Great Depression. It is necessary to evaluate the expected length of the project and utilize a risk free rate applicable for the same time period. Ameritrade is investing $100 million dollars in technology, which is considered a long-term investment, in order to become the largest brokerage firm. We consider their

In his book, Capital Ideas: The Improbable Origins of Modern Wall Street, Peter L. Bernstein examines the innovative financial work of various academics that helped shape modern Wall Street. Bernstein sets out to show that Wall Street is in fact a fundamental and useful model to follow, rather than something to be feared. He points out that, “By combining the linkage between risk and reward with the combative nature of the free market, these academics brought new insights into what Wall Street is all about and devised new methods for investors to manage their capital.” (2) These impressive scholars have incorporated scientific measurement to the art of finance, forever

Over the past year both Tesla and BMW have taken severe losses to their share prices. overall Tesla has reported a lower loss percentage in its share price, -25% compared to BMW’s reported loss of -33%. However since October 2015 BMW has reported an over loss percentage than Tesla. The six month report of the two groups shows that BMW has traded at a higher price and therefore reports a lower loss percentage of -21% compared to Tesla’s -29%. Even more recently BMW’s share prices have increased by 1% whereas Tesla’s share prices have dropped by -11%. By reporting this gain it shows that BMW stock is in greater demand meaning that investors have

The recent behaviour of US equities at such an advanced stage of an economic expansion should not be viewed as something unusual. There was a surge in stock prices in the late-1990s based on the ill-founded view that a supply-side improvement in the economy, founded on new information technology, would perpetually postpone the arrival of profit margin erosion. Investors consequently fell into the trap of believing that the benefits of technological revolution would be solely bestowed on the corporate sector, contrary to the experience of prior episodes where households had enjoyed the bulk of the benefits via lower selling prices. It comes, therefore, as no surprise that the bursting of the

Behavioral finance has also discuss about how certain groups of investors behave, and what kinds of portfolios they choose to hold and how they trade over time. It is simply to explain the actions of certain investors, and these actions also affect prices. Some of the actions of investors and the behavioral ideas are insufficient diversifation, naive diversifation,excessive trading, the selling and buying decision.

owning these stocks does not earn a return premium. Because our results can fit both explanations, they do not distinguish between the rational

Studies about determinant factors of equity return in each country is useful for global portfolio managers and global economic policy makers. Investors, in making profit, need to consider some risky aspects, to make speculation easier to be known, before investing in financial instruments in any country (Chandran et al. 2011, p.1). On the other hand, the government needs to attract capital inflow to support some development investments (Hadad cited in Hermansyah 2016).

Economic theory proposes that there should be a strong link between economic activity and stock prices, given that its price is the discounted present value of the firm’s payout. If this payout is finally a function of real activity, such a link should exist.