The work investigates the Equity Premium Puzzle as described by Siegel and Thaler in 1997. Investigations in the thesis are centered around the question of how behavioral economics can explain the anomalies of stock markets and the equity premium.
As the research question implies, this work will examine solutions of the puzzle suggested from both the field of rational economics and behavioral economics. Due to a large number of various approaches to explain the puzzle over the past 30 years, this work will concentrate on a selected number of suggestions from various economists. I will examine assumptions and conditions of the solutions suggested, and analyze key theories applied in the resolutions. The quantitative foundation of models analyzed in this work will not be examined, as this would require detailed statistical and mathematical considerations. The work is structured as follows. I will to begin with outline the initial puzzle stated by Mehra and Prescott in 1985 and analyze key assumptions of their equilibrium model. Different resolutions of the puzzle suggested by rational and behavioral economics will then be examined, followed by an investigation of the empirical evidence behind the proposed solutions. A discussion will follow, and the author will reflect on the robustness and relevance of the puzzle. A conclusion will sum up the key elements of the work.
Table of Contents
1 Introduction
2 The Equity Premium Puzzle
2.1 Investigation from a rational perspective
2.2 Investigation from a behavioral perspective
3 Empirical evidence
4 Discussion
5 Conclusion
Research Objectives and Key Topics
This work explores the "Equity Premium Puzzle"—the significant, unexplained discrepancy between high stock returns and low risk-free investment returns over a long historical period—by comparing solutions proposed by rational and behavioral economic theories.
- Analysis of the foundational Mehra-Prescott equilibrium model and its underlying assumptions.
- Examination of rational economic approaches, including disaster-state models and non-expected utility preferences.
- Exploration of behavioral explanations, specifically focusing on Prospect Theory, mental accounting, and myopic loss aversion.
- Evaluation of the empirical robustness of these theories through historical market data and experimental evidence.
Excerpt from the Book
2 The Equity Premium Puzzle
This section will examine the initial equilibrium model to calculate return on equity and risk-free investments suggested by Mehra and Prescott (1985). Key assumptions behind and the robustness of the model will be analyzed, and the subsections 2.1 and 2.2 will examine solutions proposed by rational and behavioral economics respectively.
In 1985, economists R. Mehra and E.C. Prescott suggested an equilibrium model with the purpose to calculate the return of equity and risk-free investments observed in data over a ninety-year period. Table 1 shows key data from the original research examined (Mehra and Prescott, 1985), which the model was supposed to replicate:
For the computation of their model, Mehra and Prescott considered three key assumptions.
Summary of Chapters
1 Introduction: This chapter defines the Equity Premium Puzzle as a significant economic anomaly and presents the core research question regarding the contributions of behavioral versus rational economics to its resolution.
2 The Equity Premium Puzzle: This section details the original equilibrium model by Mehra and Prescott, evaluates its core assumptions, and explores various proposed solutions from both rational and behavioral perspectives.
3 Empirical evidence: This chapter reviews the historical data and experimental results used to support or challenge the various proposed solutions to the puzzle.
4 Discussion: This section synthesizes the examined theories, critiques the "representative agent" and market completeness assumptions, and reflects on the robustness of the puzzle.
5 Conclusion: The final chapter summarizes the findings, noting that the puzzle remains a persistent phenomenon and suggests that a complete explanation may lie beyond current standard economic theories.
Keywords
Equity Premium Puzzle, Behavioral Economics, Rational Economics, Mehra and Prescott, Prospect Theory, Loss Aversion, Myopia, Risk Premium, Consumption Growth, Utility Function, Market Frictions, Empirical Evidence, Asset Pricing, Mental Accounting, Consumption Risk
Frequently Asked Questions
What is the central focus of this research paper?
The paper focuses on the Equity Premium Puzzle, which is the historical observation that the average return on stocks is significantly higher than the return on risk-free investments, a phenomenon that challenges standard economic models.
What are the primary themes discussed in the work?
The primary themes include the evaluation of standard equilibrium models, the role of risk aversion, the impact of consumption patterns, and the application of behavioral concepts like myopia and loss aversion to explain investor behavior.
What is the main research question?
The research asks if behavioral economics can contribute to an explanation of the Equity Premium Puzzle and which specific solutions are suggested by rational economic theories.
Which scientific methods are employed to analyze the puzzle?
The work employs a literature review and a comparative analysis of economic models and empirical studies, focusing on qualitative assessment rather than quantitative mathematical derivations.
What is covered in the main body of the work?
The main body examines the Mehra-Prescott equilibrium model, modifies it using rational approaches (e.g., disaster states, habit formation), and contrasts these with behavioral approaches (e.g., Prospect Theory, myopic loss aversion), followed by a review of empirical support.
Which keywords best characterize this work?
Key terms include Equity Premium Puzzle, Prospect Theory, Loss Aversion, Myopia, and equilibrium models.
How does Prospect Theory help explain the Equity Premium Puzzle?
Prospect Theory suggests that investors evaluate gains and losses relative to a reference point rather than absolute wealth, and because losses are perceived as more painful than equivalent gains are pleasurable, investors demand a higher premium to hold risky assets.
What is the concept of "myopic loss aversion"?
Myopic loss aversion is the combination of loss aversion and frequent evaluation of investment performance, which leads investors to perceive more risk in stocks and consequently demand a higher equity premium.
Does the author conclude that the puzzle has been solved?
No, the author concludes that the puzzle is quite robust and that no single, universally accepted solution exists, suggesting it may be viewed as an empirical fact rather than a simple puzzle.
- Citar trabajo
- Anonym (Autor), 2018, Behavioral Economics and the Equity Premium Puzzle. Which Solutions Do Rational Economist Suggest?, Múnich, GRIN Verlag, https://www.grin.com/document/1010174
