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Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good to Be True?

Stephen G. Cecchetti, Pok-sang Lam and Nelson C. Mark
The American Economic Review
Vol. 90, No. 4 (Sep., 2000), pp. 787-805
Stable URL: http://www.jstor.org/stable/117308
Page Count: 19
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Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good to Be True?
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Abstract

We study a Lucas asset-pricing model that is standard in all respects, except that the representative agent's subjective beliefs about endowment growth are distorted. Using constant relative risk-aversion (CRRA) utility, with a CRRA coefficient below 10; fluctuating beliefs that exhibit, on average, excessive pessimism over expansions; and excessive optimism over contractions (both ending more quickly than the data suggest), our model is able to match the first and second moments of the equity premium and risk-free rate, as well as the persistence and predictability of excess returns found in the data.

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