An exploration of the effects of pessimism and doubt on asset returns
The subjective distribution of growth rates of aggregate consumption is characterized by pessimism if it is first-order stochastically dominated by the objective distribution. Uniform pessimism is a leftward translation of the objective distribution of the logarithm of the growth rate. The subjective distribution is characterized by doubt if it is mean-preserving spread of the objective distribution. Pessimism and doubt both reduce the riskfree rate and thus can help resolve the riskfree rate puzzle. Uniform pessimism and doubt both increase the average equity premium and thus can help resolve the equity premium puzzle.
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