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

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.