Equity premium with distorted beliefs: A puzzle

In a recent attempt to explain the equity-premium puzzle, Cecchetti, Lam, and Mark (2000) relax the assumption of rational expectations, and replace it by a form of persistent irrationality. The authors demonstrate that, for a judicious choice of parameters, the resulting model can explain the puzzle. We take a closer look at the results and reach a puzzling conclusion: the model used to explain the puzzle can generate contradictory results without any change in parameter values. Without a clear rule for determining which set of results is to be taken as representative, the explanatory validity of this type of model remains questionable. Wider implications of these findings are suggested. (c) 2005 Elsevier B.V. All rights reserved.