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Citing the paper Volatility-induced financial growth (2007) by Dempster et al.:

when asset returns are stationary ergodic, their volatility, together with any fixed-mix trading strategy, generates a portfolio growth rate in excess of the individual asset growth rates. As a consequence, even if the growth rates of the individual securities all have mean zero, the value of a fixed-mix portfolio tends to infinity with probability one

Here is the link I am suggesting:

1) The case of equity value: Equity value is a function of the company's assets, i.e. equity is a portfolio of assets. Assume that managers rebalance the investments in companies using a fixed-mix strategy and that transaction costs are subject to the restriction in the above cited paper.

2) The case of a treasury bond: A treasury bond does not hold the properties needed to use this volatility-induced financial growth. There is no underlying asset portfolio which one can rebalance within a treasury bond.

Conclusion: Because managers rebalance asset portfolios the volatility-induced financial growth has assured the magnitude of equity returns above treasury bond returns which lead to the puzzle in the first place.

Does this hold as a viable theory?

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No,no, and no. Equity returns are higher than treasury bond return because of the higher real risk of a host of risk components. They are also higher than the same company corporate bond for reasons of subordination. Glancing over references such as this give me a stomachache because it shows such utter disregard for the basics of financial market dynamics while trying to blow up a paper with complicated terms to sound academically sophisticated. –  Matt Wolf Jun 23 '13 at 21:44
Had a closer look at the paper and it again shows how most any engineer, mathematician, or computer science major can analyze time series without knowing a thing about financial markets. Their "surprising" results that volatility can be interpreted as risk but also as a driver for more market participation and a surge in equity markets is one of the most basic principles in finance, something every new grad learns in the first week "on the desk". Number for Japan just came out, Japanese retail participation increased from 29% to 43% in May due to Nikkei volatility. –  Matt Wolf Jun 24 '13 at 0:13

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