Ever since the equity premium puzzle (EEP) was published by Mehra and Prescott (1985), it has become one of the most investigated problems in economics (Mehra, 2003, p. 54). The EEP describes the fact that we cannot link historic stock returns with the volatility of consumption growth (in a sense to be made precise below). Mehra and Prescott call this a puzzle as their consumption-based asset pricing model can not plausibly explain the S&P 500’s annual risk premium of 6.2% over relatively risk-free governmental treasury bills between 1889 and 1978. This model reproduces an equity premium of 6.2% solely by adapting unreasonable estimates of agents’ risk aversion (Mehra & Prescott, 1985, pp. 155-156). In this way, the model also predicts an extreme size of the risk-free rate (Cochrane, 2000, p. 416). Thus, the equity premium is not able to be explained exclusively by the risk of stock price fluctuations.
(...) This thesis will examine the EPP from a behavioral perspective. The major research question to be pursued is this: How do behavioral approaches explain the equity premium puzzle? In order to answer this question, a variety of subtasks must be addressed. This includes the investigation of the initial model of Mehra and Prescott (1985) as well as its underlying assumptions. That is, in particular, needed because several well-established classical assumptions must be dropped to set up descriptive behavioral models. In addition, implications from psychology and behavioral economics must be introduced to answer the overall question of this thesis. Hence, the thesis will focus on the notions of loss aversion, narrow framing, and regret theory in an effort to explain the EPP.
(...) The remainder of this thesis is organized as follows: Chapter 2 investigates the EPP and its predictions. This chapter considers potential failures of the model, especially the violations of expected utility theory which may lead to the puzzling results. Chapter 3 focuses on the behavioral concepts of prospect theory and mental accounting. Based on those concepts, chapter 4 deals with myopic loss aversion in an effort to explain the EPP. Chapter 5 discusses regret theory as another behavioral concept. This chapter also proposes an explanation of the EPP from a regret perspective. Chapter 6 concludes and discusses potential directions for future research.
Inhaltsverzeichnis
- Introduction
- The Equity Premium Puzzle
- The Model
- Empirical Observations and the Predictions of the Model
- Approaches to the Puzzle
- Potential Failures of the Model
- The Risk Aversion of Investors
- Consumption-Based Asset Pricing
- Violations of Expected Utility Theory
- Prospect Theory and Mental Accounting
- Prospect Theory
- The Axioms of Expected Utility Theory
- The Value Function
- The Weighting Function
- Mathematical Notions of Prospect Theory
- Loss Aversion
- Mental Accounting
- Myopic Loss Aversion and the Equity Premium Puzzle
- Implications from Prospect Theory and Mental Accounting for the Equity Premium
- Myopic Loss Aversion Approaches to the Equity Premium Puzzle
- Explanation With Myopic Loss Aversion
- Explanation With Consumption, Narrow Framing, and Loss Aversion
- Investor Preferences
- Results
- Incorporating Historical Consumption and Dividend Correlation
- Remarks on Myopic Loss Aversion
- Regret Theory and the Equity Premium Puzzle
- The Intuition Behind Regret Theory
- Linking Regret Theory, Prospect Theory, and Narrow Framing
- Formal Model of Regret Theory
- Explaining the Equity Premium Puzzle With Regret
- Conclusion
- References
- Appendixes
Zielsetzung und Themenschwerpunkte
This thesis aims to explore the behavioral explanation of the Equity Premium Puzzle (EPP). The EPP refers to the historically observed higher returns on stocks compared to bonds, which is difficult to reconcile with traditional financial models. The thesis investigates how behavioral biases, particularly myopic loss aversion and regret theory, can contribute to explaining this puzzle.
- The Equity Premium Puzzle and its implications for traditional financial models
- Behavioral biases, including myopic loss aversion and regret theory
- The role of prospect theory and mental accounting in explaining the EPP
- Empirical evidence and theoretical models supporting the behavioral explanation of the EPP
- The limitations and potential extensions of behavioral models in explaining the EPP
Zusammenfassung der Kapitel
The introduction provides a brief overview of the Equity Premium Puzzle and its significance in financial economics. It outlines the key questions and challenges that the puzzle presents, setting the stage for the subsequent analysis.
Chapter 2 delves into the theoretical framework of the Equity Premium Puzzle, presenting the standard model and its predictions. It then examines the empirical observations that contradict these predictions, highlighting the puzzle's core problem. The chapter also explores various approaches to addressing the puzzle, including traditional explanations based on risk aversion and consumption-based asset pricing.
Chapter 3 focuses on potential failures of the standard model, particularly the assumption of rational investors and their adherence to expected utility theory. It introduces prospect theory and mental accounting as alternative frameworks for understanding investor behavior. The chapter provides a detailed explanation of prospect theory, including its key components like the value function, weighting function, and loss aversion.
Chapter 4 examines the implications of myopic loss aversion for the Equity Premium Puzzle. It explores how this behavioral bias, stemming from prospect theory and mental accounting, can contribute to explaining the observed higher returns on stocks. The chapter presents various models and empirical evidence supporting the myopic loss aversion approach to the puzzle.
Chapter 5 introduces regret theory as another behavioral explanation for the Equity Premium Puzzle. It discusses the intuition behind regret theory and its connection to prospect theory and narrow framing. The chapter presents a formal model of regret theory and explores how it can explain the puzzle by incorporating the potential for regret in investment decisions.
Schlüsselwörter
The key words and focus themes of the text include the Equity Premium Puzzle, behavioral finance, myopic loss aversion, regret theory, prospect theory, mental accounting, risk aversion, consumption-based asset pricing, and expected utility theory. The text explores how these concepts can contribute to understanding the observed higher returns on stocks compared to bonds, challenging traditional financial models and offering alternative explanations for investor behavior.
- Citar trabajo
- Kevin Rink (Autor), 2010, Behavioral Explanation of the Equity Premium Puzzle, Múnich, GRIN Verlag, https://www.grin.com/document/149884
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