Behavioral Explanation of the Equity Premium Puzzle

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

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.