EFF: There never was one. The "puzzle" comes out of a simplified economic model that says the average spread of the equity market return over the t-bill return has been too high, given the risk of equities. It is easy to show that this argument is silly. Thus, the returns from equity investing are quite risky. As a result, if the high average stock return of the past is the true long-term expected return, the high volatility of stock returns nevertheless means that getting a positive equity premium (of any size) is highly likely only for holding periods of 35 years (an investment lifetime) or more. Given this result, the historical equity premium does not seem too high.

EFF: All the evidence I know says that market predictions are unbiased. It's understandable, however, that hedge fund managers are immune to this evidence since it's a threat to their existence.

EFF/KRF: We are not experts, but know enough about the academic research to be skeptical of the signals suggested by casual observers. The academics who study this find that the best leading indicators are not very powerful. It is hard to say when the recession will end until it has.

From an investment perspective, the market is always doing its best to incorporate information about future business conditions in current prices. As a result, other signals about the end of the recession are not likely to help you forecast the market.

EFF: The term "systemic risk" is less than 20 years old. It has become a scare term that governments use to justify bailout actions detrimental to taxpayers.

"Too big to fail" is an especially perverse use of the systemic risk scare tactic. I think the policy rule should be "too big not to fail," that is, big losers among financial firms get shut down first, to signal other big financial firms that "too big to fail" bailouts are over, so the firms will behave more responsibly in the future.

EFF/KRF: There is no single right answer to this question. If there were one answer, it would have to be the market portfolio of domestic, international, and emerging stocks, since that is the only portfolio that can be held by everyone. Different tastes and circumstances, however, push investors away from the market portfolio and the optimal deviations vary across investors. For example, perhaps because of exchange rate uncertainty, people tend to overweight their domestic market. Similarly, some investors are happy to increase their expected return by tilting toward small stocks, while others prefer to reduce their risk by tilting toward large caps. It is important to diversify, but there is no single optimal mix.

EFF/KRF: No. Although the expected market return probably increased over the last year, this is the result of greater uncertainty about future returns and perhaps an increase in the overall level of risk aversion. If your client's circumstances warrant a reduction in risk, an increase in expected return that is caused by an increase in risk is not a good reason to stay in the market.

EFF/KRF: In our research we calculate the E/P ratio for a portfolio just as S&P does, dividing the aggregate earnings of the firms in the portfolio by the total market equity. It is easy to see the logic if you imagine merging all of the firms into one giant conglomerate. The new firm's earnings and market equity are just the sum of the individual firms' earnings and market equity.

EFF: Wins and losses from market timing bets are both just unpredictable chance outcomes, and good luck is, of course, better than bad luck. The problem with market timing is that you may be out of the market in periods of strong returns.

KRF: There is a large academic literature on whether market returns are predictable. The general conclusion is that it is impossible to predict the market return with any confidence... "A Comprehensive Look at the Empirical Performance of Equity Premium Prediction," by Amit Goyal and Ivo Welch (Review of Financial Studies, 2008), is a good summary of the evidence.

EFF/KRF: Inverted yield curves are often observed at the front end of recessions. But there's no evidence that they predict stock returns, which also tend to predict (decline in advance of) recessions. Your client's implicit premise is that bond market investors predict future economic activity better than stock market investors. The evidence says that both markets are moderately good at predicting future economic activity, and inverted yield curves are not reliable predictors of stock returns.

EFF: It gives investors a good estimate of what a financial institution is worth. It has more flexibility than commonly realized, especially for illiquid assets, where best estimates of value can be used.

KRF: There is not enough empirical evidence to be sure who is right about this issue, but we can guess. Those against marking to market argue that the transaction prices for securities sold under duress do not reflect their true value. If you and I both own relatively illiquid assets and you choose to sell yours quickly at a fire sale price, mark to market accounting may force me to write down the value of my assets to your transaction price. Unless I also plan to sell my position quickly, this undervalues my position. The critical question, however, is whether your transaction price is more accurate than the model value I would use if I am not forced to mark to market. My guess—and this is only a guess—is that the observed transaction price is typically more accurate than the model. In other words, marking to market would improve the accuracy of my balance sheet.