Rational Beliefs or Distorted Beliefs: Equity Premium Puzzle and Micro Survey Data

Abstract

This paper examines whether the Sharpe ratios constructed from survey forecasts are favorable to the rational approach or the irrational approach in explaining the equity premium puzzle. T-tests, bias tests, and structural break tests for the bias are conducted for the examination. The results appear more favorable to the irrational approach. The average Sharpe ratios constructed from the Livingston survey forecasts lie within the Hansen-Jagannathan bound in most cases. Almost all individual economists have significant biases in forecasts. Furthermore, those biases seem to vary over the business cycle, which is consistent with a seemingly ad hoc assumption in the irrational approach.Survey forecasts, Rational expectation, Habit formation, Distorted beliefs, T-tests, Bias tests