Alexander Adamou, Ole Peters

Paper #: 13-06-022

In (Peters, 2011a) it was shown that the time-average growth rate of a leveraged investment defines an objectively optimal leverage. It was speculated that this optimal leverage should be close to 1, implying that the simple strategy of leveraging or deleveraging an investment in the market portfolio cannot outperform the market in the long run. This places a strong constraint on the possible stochastic properties of the market, which we call "stochastic market efficiency." Market conditions that deviate significantly from stochastic efficiency are unstable and may lead to leverage-driven bubbles. Historical data confirm the hypothesis. This also resolves the so-called "equity premium puzzle" (Mehra and Prescott, 1985).