  Proponents of behavioral finance have identified several "puzzles" in the
market that are inconsistent with rational finance theory. One such puzzle is
the "excess volatility puzzle". Changes in equity prices are too large given
changes in the fundamentals that are expected to change equity prices. In this
paper, we offer a resolution to the excess volatility puzzle within the context
of rational finance. We empirically show that market inefficiency attributable
to the volatility of excess return across time is caused by fitting an improper
distribution to the historical returns. Our results indicate that the variation
of gross excess returns is attributable to poorly fitting the tail of the
return distribution and that the puzzle disappears by employing a more
appropriate distribution for the return data. The new distribution that we
introduce in this paper that better fits the historical return distribution of
stocks explains the excess volatility in the market and thereby explains the
volatility puzzle. Failing to estimate the historical returns using the proper
distribution is only one possible explanation for the existence of the
volatility puzzle. However, it offers statistical models within the rational
finance framework which can be used without relying on behavioral finance
assumptions when searching for an explanation for the volatility puzzle.
