Solving the Equity Risk Premium Puzzle and Inching Towards a Theory of Everything -- Visual Version

Abstract

The equity risk premium puzzle is that the return on equities has far exceeded the average return on short-term risk-free debt and cannot be explained by conventional representative-agent consumption based equilibrium models. We review a few attempts done over the years to explain this anomaly:1. Inclusion of highly unlikely events with low probability (Ugly state along with Good and Bad), or market crashes, recently also termed as Black Swans.2. Slow moving habit, or time-varying subsistence level, added to the basic power utility function.3. Allowing for a separation of the inter-temporal elasticity of substitution and risk aversion, combined with consumption and dividend growth rates modeled as containing a small persistent expected growth rate component and a fluctuating volatility which captures time varying economic uncertainty.We explore whether a fusion of the above approaches supplemented with better methods to handle the below reservations would provide a more realistic and yet tractable framework to tackle the various conundrums in the social sciences:1. Unlimited ability of individuals to invest as compared to their ability to consume.2. Lack of an objective measuring stick of value which gives rise to heterogeneous preferences and beliefs.3. Unintended consequences due to the dynamic nature of social systems, where changes can be observed and decisions effected by participants to influence the system.4. Relaxation of the transversality condition to avoid the formation of asset price bubbles.5. How durable is durable? Since nothing lasts forever, accounting for durable goods to create a comprehensive measure of consumption volatility .The world we live in produces fascinating phenomenon despite (or perhaps, due to) being a hotchpotch of varying doses of the above elements. The rationale for a unified theory is that beauty can emerge from chaos since the best test for a stew is its taste.