Comments on: Marty Weitzman on the equity premium

By: dsquared

dsquared — Tue, 17 Aug 2004 21:39:24 +0000

Jason; yes, absolutely, but it turns out that even if you calculate it correctly, the problem is still there.

By: woodturtle

woodturtle — Tue, 17 Aug 2004 20:23:21 +0000

I thought the intent of the post was to introduce some new vocabulary words, and they are some doozies. I’m about one-third the way through. All I can say about that guy- he needs to get out more.

By: Jason

Jason — Tue, 17 Aug 2004 14:18:20 +0000

Dan/John, I have a question (since I don’t know all that much about the Equity gap literature). Almost all of the papers or discussions I see focus on the fact that the “average rate of return” for equities is too high. Isn’t average rate of return the wrong thing to be measuring because we are dealing with products not sums? As an extreme case, suppose 1 year I have a 200% return, and the next year I have a -100% return, then my average rate of return is 50%, despite me having no money at all. The measurement should be the expected value of the log of 1 + the return (E log (1+r)) rather than Er. Of course, this doesn’t take into account time preference as easily but it does demonstrate that average rate of return will overestimate actual return (Jensen’s inequality gives it generally).

By: Dirk Jenter

Dirk Jenter — Tue, 17 Aug 2004 05:26:12 +0000

John, I mostly meant the earlier paper by Pastor and Stambaugh, I think from 1999, and Lubos Pastor’s job market paper, published in 2000. But instead on relying on the bad memory of someone who has not really been thinking about these papers for years, I walked across the hall and talked to some people who actually have a clue. Here is the recommended reading list I received for Bayesian models related to the equity premium puzzle: Anything by Kandel and Stambaugh, especially their 1996 JF paper. Anything by Brennan and Xia, especially their 2001 JME paper. Pietro Veronesi (1999 RFS). Lewellen and Shanken (2002 JF). Bansal and Yaron (2004, forthcoming JF). I do not know how complete this list is, but I think it confirms my impression that Weitzman is probably not the first one to apply Bayesian methods to optimal portfolio selection and / or the related equilibrium models.

By: John Quiggin

John Quiggin — Tue, 17 Aug 2004 02:00:30 +0000

Thanks Dirk and sorry if I was a little touchy. I downloaded the Pastor-Stambaugh paper on structural breaks from NBER, which looks interesting and relevant, but doesn’t seem to discuss the implied degree of risk aversion.Is that the one you meant? Baberis also sounds interesting, though, as you say, slightly tangential. I’ll chase it as soon as I get some free time.

By: Dirk Jenter

Dirk Jenter — Mon, 16 Aug 2004 21:45:40 +0000

John, I apologize if I sounded disrespectful, I actually read your survey arcticle with Simon Grant (if that’s the one you mean) a few months ago and learned a lot from it. There was a lot of talk about both Bayesian learning and robust control approaches to tackling the equity premium puzzle in the Harvard Econ department when I did my PhD there (1997-2002), with John Campbell and Gary Chamberlain encouraging students to work along these lines. Nicholas Baberis had graduated just before I arrived and gone to Chicago, but came back as a visitor and taught asset pricing to us in my seond year. His job market paper on optimal portfolio choice under parameter uncertainty was published in the Journal of Finance in 2000. His modelling approach was really simple, but other people have by now added a lot of technical bells and whistles. A little later than Barberis, Lubos Pastor was doing his PhD at Wharton under Rob Stambaugh and worked on both model and parameter uncertainty. Lubos Pasor went to Chicago and you should be able to find his papers on this webpage there, including a very relevant paper written with Stambaugh.

By: Dirk Jenter

Dirk Jenter — Mon, 16 Aug 2004 21:44:41 +0000

John, I apologize if I sounded disrespectful, I actually read your survey arcticle with Simon Grant (if that’s the one you mean) a few months ago and learned a lot from it. There was a lot of talk about both Bayesian learning and robust control approaches to tackling the equity premium puzzle in the Harvard Econ department when I did my PhD there (1997-2002), with John Campbell and Gary Chamberlain encouraging students to work along these lines. Nicholas Baberis had graduate just before I arrived and gone to Chicago, but came back as a visitor and taught asset pricing to us in my seond year. His job market paper on optimal portfolio choice under parameter uncertainty was published in the Journal of Finance in 2000. His modelling approach was really simple, but other people have by now added a lot of technical bells and whistles. A little later than Barberis, Lubos Pastor was doing his PhD at Wharton under Rob Stambaugh and worked on both model and parameter uncertainty. Lubos Pasor went to Chicago and you should be able to find his papers on this webpage there, including a very relevant paper written with Stambaugh.

By: John Quiggin

John Quiggin — Mon, 16 Aug 2004 21:05:56 +0000

Dirk, both Brad DeLong and I have published articles on the equity premium in major journals. I’ve even written a (so far unpublished), survey article. Describing us as “equally unfamiliar with the field” doesn’t seem entirely accurate. The literature on the equity premium is gigantic, and no-one nowadays can be aware of every paper. In addition, as I point out in my post, it’s well-known that the basic idea has been tried before, most obviously by Riesz – Weitzman’s innovation is in having a fully Bayesian approach. I will chase the papers you mention, however.

By: Dirk Jenter

Dirk Jenter — Mon, 16 Aug 2004 15:07:00 +0000

John, I agree with your assessment that the equity premium puzzle is most likely caused by several factors. What bothers me about the Weitzman paper, and the blogosphere reaction to it, is that he is far from the first one to introduce model and / or parameter uncertainty into the consumption CAPM in a Bayesian framework. I am a corporate finance person, not an asset pricer, but I vividly remember sitting in seminars by Lubos Pastor and Rob Stambaugh at least six or seven years ago in which they presented models along these line. They even incorporated Bayesian learning into their models, at least if my memory doesn’t fail me. Also, Nick Baberis job market paper had a simple model of optimal portfolio choice under parameter uncertainty. I haven’t read the Weitzman paper yet, but my guess right now is that this is a case of somebody blissfully unaware of the literature in a field (that is not his) doing some work that has been done long before, and people who are equally unfamiliar with the field getting all excited because it is the first time they hear about the result.

By: Andrew Edwards

Andrew Edwards — Mon, 16 Aug 2004 14:31:18 +0000

John: Will you post a link when the Weitzman paper comes online? I’m sure we’d all love to read it. Otherwise I’ll trot down to the U of T campus and bug Henry for a copy. :-)

By: Mats

Mats — Mon, 16 Aug 2004 12:28:59 +0000

“My general view is that there is no one explanation of the equity premium, but a set of problems with the standard consumption-based model of asset pricing (CCAPM)” – This standpoint seems safe enough. Consider the alternative: because of shortcomings in the basic description of uncertainty, economists have for decades failed to describe such basic entities in the economy as the approximate levels of asset returns (and what else…). An impressing display of smartness?

By: John Quiggin

John Quiggin — Mon, 16 Aug 2004 11:16:54 +0000

This is a near-final version of the Grant-Quiggin paper. As I mentioned, I don’t have access to a proper version of the Weitzman paper yet.

By: John Quiggin

John Quiggin — Mon, 16 Aug 2004 11:12:55 +0000

Brett, the problem here is that the activities where automation is feasible are, in most cases, shrinking relative to national income. Meanwhile, activities like health care are growing. This occurs because, mostly, own-price elasticities are less than one.

By: Brett Bellmore

Brett Bellmore — Mon, 16 Aug 2004 10:59:00 +0000

“With less confidence, I’d assert that there are pretty good technological reasons to rule out a sustained rate of productivity growth (embodied and disembodied) of more than 5 per cent, for countries that are already at the frontier. The maximum sustainable rate of growth of output per person cannot be much above this.” Interesting; I’d say quite the opposite. Considering that much productivity today is the productivity of machines, not people, and that automation engineers are bcoming more and more successful at “closing the loop”, (Look at the phenomnenon of “lights out” factories.) it’s entirely plausible that in the relatively near future productivity in a great deal of the industrial economy won’t be tied to human labor. A rate of growth based solely on raw materials and energy contraints could, for at least a short while, exceed 100% per year. But “sustained”? No, I suppose not, unless we got off planet. “Sustained” high rates of growth would run up against the limits of energy and the Earth’s heat budget fairly quickly. A typical “S” curve of growth as seen all the time in biology is more plausible.

By: Dick Thompson

Dick Thompson — Mon, 16 Aug 2004 01:35:20 +0000

John, could you provide a link to that PDF? ‘twould be much appreciated.