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.
Table of Contents
1 Introduction
2 The Equity Premium Puzzle
2.1 The Model
2.2 Empirical Observations and the Predictions of the Model
2.3 Approaches to the Puzzle
2.4 Potential Failures of the Model
2.4.1 The Risk Aversion of Investors
2.4.2 Consumption-Based Asset Pricing
2.4.3 Expected Utility Theory
2.4.3.1 The Axioms of Expected Utility Theory
2.4.3.2 Violations of Expected Utility Theory
3 Prospect Theory and Mental Accounting
3.1 Prospect Theory
3.1.1 The Value Function
3.1.2 The Weighting Function
3.1.3 Mathematical Notions of Prospect Theory
3.1.4 Loss Aversion
3.2 Mental Accounting
4 Myopic Loss Aversion and the Equity Premium Puzzle
4.1 Implications from Prospect Theory and Mental Accounting for the Equity Premium
4.2 Myopic Loss Aversion Approaches to the Equity Premium Puzzle
4.2.1 Explanation With Myopic Loss Aversion
4.2.2 Explanation With Consumption, Narrow Framing, and Loss Aversion
4.2.2.1 Investor Preferences
4.2.2.2 Incorporating Historical Consumption and Dividend Correlation
4.2.2.3 Results
4.3 Remarks on Myopic Loss Aversion
5 Regret Theory and the Equity Premium Puzzle
5.1 The Intuition Behind Regret Theory
5.2 Linking Regret Theory, Prospect Theory, and Narrow Framing
5.3 Formal Model of Regret Theory
5.4 Explaining the Equity Premium Puzzle With Regret
6 Conclusion
Research Objectives and Themes
This thesis examines the Equity Premium Puzzle (EPP) from a behavioral economics perspective, aiming to identify how non-classical assumptions, such as those found in prospect theory, mental accounting, and regret theory, can provide a more accurate explanation for the equity risk premium than traditional consumption-based asset pricing models.
- Investigation of the initial Mehra and Prescott (1985) model and its inherent classical limitations.
- Analysis of prospect theory and its components, including loss aversion and the value function.
- Application of mental accounting and narrow framing to explain investor decision-making.
- Development of behavioral explanations for the equity premium, specifically through myopic loss aversion and regret theory.
Excerpt from the Book
3.1.1 The Value Function
In order to capture the prospective value of outcomes, Kahneman and Tversky (1979) propose a hypothetical value function (see Figure 3). In contrast to expected utility theory, the value function does not account for the state of wealth of an individual but for the changes in wealth and, thus, for gains and losses with respect to a particular reference point (Kahneman & Tversky, 1979, p. 277). The reference point constitutes a state prior to decisions. It, therefore, effectively separates gains from losses (Kahneman & Tversky, 1992, p. 303). Apart from that, the previously shown problems revealed that individuals are risk-averse in the domain of gains and risk-seeking in the domain of losses. Accordingly, the value function is concave for gains and convex for losses. Hence, a change in wealth from $0 to $10 is valued more than a change from $1000 to $1010, expressing diminishing sensitivity. The same intuition applies to the pain one perceives through losses. Furthermore, Kahneman and Tversky (1991) refer to the general loss aversion of individuals, meaning that a gamble with equal chances to win and to lose the same amount is usually neglected. This means that v(X) < -v(-X) for X > 0 and, as a result, implies a more steeply shaped function for losses than for gains.
Summary of Chapters
1 Introduction: Introduces the Equity Premium Puzzle as defined by Mehra and Prescott and outlines the necessity of behavioral approaches to address its shortcomings.
2 The Equity Premium Puzzle: Investigates the classical consumption-based asset pricing model and explains why it fails to account for empirical stock returns and risk-free rates.
3 Prospect Theory and Mental Accounting: Details behavioral concepts that deviate from expected utility theory, focusing on the value function, probability weighting, and how individuals categorize financial outcomes.
4 Myopic Loss Aversion and the Equity Premium Puzzle: Applies prospect theory and mental accounting to show how evaluation periods and loss aversion influence the required equity risk premium.
5 Regret Theory and the Equity Premium Puzzle: Explores how regret aversion affects asset allocation and potential market volatility compared to purely rational behavior.
6 Conclusion: Summarizes the findings and discusses the implications of behavioral approaches for future economic research.
Keywords
Equity Premium Puzzle, Behavioral Economics, Prospect Theory, Mental Accounting, Myopic Loss Aversion, Regret Theory, Loss Aversion, Risk Aversion, Narrow Framing, Asset Pricing, Expected Utility Theory, Consumption-based Modeling, Investor Preferences, Stock Returns, Financial Anomalies.
Frequently Asked Questions
What is the primary subject of this thesis?
The thesis investigates the "Equity Premium Puzzle" (EPP), which is the observed discrepancy between the historically high returns on equity and the relatively low risk-free rates, a gap that traditional economic models fail to explain adequately.
What are the central themes explored in the work?
The core themes are behavioral economic concepts, specifically prospect theory, mental accounting, myopic loss aversion, and regret theory, and how they offer alternative explanations for financial phenomena that violate standard rational choice theory.
What is the primary objective of this research?
The primary goal is to answer how behavioral approaches can explain the equity premium puzzle by replacing rigid classical assumptions about rational utility maximization with more descriptive, psychologically grounded models of human behavior.
Which scientific methods are employed?
The thesis employs a theoretical and analytical review of existing literature, evaluating formal economic models (like the Mehra-Prescott model) and comparing them against behavioral frameworks and empirical findings from experiments conducted by researchers like Kahneman, Tversky, and Thaler.
What topics are covered in the main body?
The main body systematically breaks down the EPP, details the axioms and failures of expected utility theory, explains the mechanics of the value and weighting functions in prospect theory, and models how myopic loss aversion and regret influence investor asset allocation.
Which keywords characterize this work?
The work is characterized by terms such as Equity Premium Puzzle, Myopic Loss Aversion, Prospect Theory, Mental Accounting, Regret Theory, and Loss Aversion.
How does narrow framing contribute to the Equity Premium Puzzle?
Narrow framing suggests that investors evaluate their portfolios too frequently, leading them to feel losses more acutely than they would if they viewed their investments over a longer time horizon, thus requiring a higher premium to hold risky assets.
What does the "reflection effect" imply for investor behavior?
The reflection effect implies that while individuals are generally risk-averse when dealing with potential gains, they tend to exhibit risk-seeking behavior when faced with certain losses, which contradicts the standard assumptions of utility theory.
- Citar trabajo
- Kevin Rink (Autor), 2010, Behavioral Explanation of the Equity Premium Puzzle, Múnich, GRIN Verlag, https://www.grin.com/document/149884
