Measuring the Madness of the Crowd

Abstract

The author presents a methodology for analyzing an equity market's risk premium in order to evaluate the extent of investor enthusiasm priced into the market. The author begins by analyzing the outcomes of a simple coin toss game. This same methodology is then applied to the ‘equity game’ to identify the maximum price a person is willing to pay relative to the expected payoffs he or she may experience. He similarly analyzes international equity market to gain insights into their relative performance compared to the U.S. market. Applying his equity pricing formula to five other developed equity markets – using stock market data since the end of World War II – he concludes that this methodology cannot only help understand why the market has done well historically, but also better predict how the market might perform in the future.