Investments, tenth edition

 Figure 13.6 

Alphas of value-weighted portfolios sorted on liquidity betas 

  Source: L. Pástor and R. F. Stambaugh, “Liquidity Risk and Expected Stock Returns,”  Journal of Political Economy  

111 (2003), pp. 642–85, Table 4. Copyright © 2003, The University of Chicago Press. 

−2

−4

−6

−8

4

2

Lowest

2

3

4

Illiquidity Decile

5

6

7

8

9

Highest

0

Alpha (% per year)

CAPM alpha

FF alpha

    13.5 

Consumption-Based Asset Pricing 

and the Equity Premium Puzzle 

  In a classic article, Mehra and Prescott observed that historical excess returns on risky 

assets in the U.S. are too large to be consistent with economic theory and reasonable levels 

of risk aversion.  

34

   This observation has come to be known as the “equity premium puzzle.” 

The debate about the equity premium puzzle suggests that forecasts of the market risk 

premium should be lower than historical averages. The question of whether past returns 

provide a guideline to future returns is sufficiently important to justify stretching the scope 

of our discussions of equilibrium in capital markets.