Numerous studies have provided evidence of two equity return anomalies in recent years. The “risk-premium puzzle” is the anomaly that equity returns have been excessive relative to risk. The “small-firm effect” is the anomaly that risk premiums on small-cap stocks have been excessive relative to premiums on large-cap stocks. We present unique evidence that both of these anomalies may be caused by the presence of ambiguity. More generally, we propose that the current conceptions of risk are too limited to explain equity returns and, therefore, that the distinction between risk and uncertainty developed by Frank Knight approximately 80 years ago be revisited. As numerous other studies have found, risk in the traditional sense is primarily a function of the possibility of incurring a loss. Uncertainty (ambiguity) is directly related to lack of information and lack of confidence in estimating future distributions of possible returns and the possibility of incurring a loss.
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