Are Distorted Beliefs Too Good to be True?

In a recent attempt to account for the equity-premium puzzle within a representative-agent model, Cecchetti, Lam, and Mark (2000) relax the assumption of rational expectations and in its place use the assumption of distorted beliefs. The author shows that the explanatory power of the distorted beliefs model is due to an inconsistency in the model and that an attempt to remove this inconsistency removes the model's explanatory power. Using the theory of rational beliefs, the author constructs a model in which the inconsistency is not present, compares its performance with that of the distorted beliefs model, and gives a simple interpretation of the results obtained.

Also published as:

Equity premium with distorted beliefs: A puzzle
Journal of Economic Dynamics and Control (0165-1889)
August 2006. Vol. 30, Iss. 8, pp. 1431-40