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 (Table of Contents)
- 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 and Mental Accounting
- Prospect Theory
- 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
- 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
Zielsetzung und Themenschwerpunkte (Objectives and Key Themes)
This thesis aims to explore behavioral explanations for the Equity Premium Puzzle (EPP). It investigates how deviations from the standard expected utility theory, specifically focusing on prospect theory, mental accounting, and regret theory, can help explain the observed discrepancy between the returns of stocks and bonds.
- The Equity Premium Puzzle and its implications
- Prospect Theory and its application to financial markets
- Mental Accounting and its impact on investment decisions
- Regret Theory as an alternative explanation for the EPP
- The role of investor behavior in asset pricing
Zusammenfassung der Kapitel (Chapter Summaries)
Introduction: This chapter introduces the Equity Premium Puzzle (EPP), highlighting the discrepancy between the observed returns of stocks and bonds and the predictions of traditional financial models. It sets the stage for exploring behavioral finance approaches to explain this anomaly.
The Equity Premium Puzzle: This chapter presents the standard model for asset pricing, detailing its assumptions and predictions. It then contrasts these predictions with empirical observations, clearly demonstrating the existence and magnitude of the EPP. Different approaches to resolving the puzzle are briefly introduced, setting the groundwork for the detailed examination of behavioral explanations in subsequent chapters. The chapter concludes by highlighting potential shortcomings of the standard model, such as the assumption of rational investor behavior and the limitations of the expected utility framework. This lays the foundation for exploring alternative behavioral models in later sections.
Prospect Theory and Mental Accounting: This chapter provides a thorough explanation of Prospect Theory, a behavioral model that challenges the assumptions of expected utility theory. Key features like the value function (concave for gains, convex for losses) and the weighting function (overweighting of small probabilities) are discussed, along with their implications for decision-making under risk. Mental accounting, a cognitive framework describing how individuals categorize and treat money, is also explained. The chapter elaborates on how these concepts deviate from the rational expectations of standard models, laying the groundwork for their application in resolving the equity premium puzzle. The integration of these two concepts provides a robust behavioral framework for understanding deviations from rational economic behavior in financial markets.
Myopic Loss Aversion and the Equity Premium Puzzle: This chapter explores how myopic loss aversion—the tendency to focus on short-term losses and underweight long-term gains—can contribute to the EPP. The chapter explains how prospect theory and mental accounting, detailed in the previous chapter, combine to create myopic loss aversion and lead to risk aversion in equity investments. It discusses different models that incorporate myopic loss aversion and how these models can explain the persistent difference between stock and bond returns. Different interpretations of investor preferences and the incorporation of historical consumption and dividend correlations are further examined, adding layers of complexity to this behavioral explanation of the EPP.
Regret Theory and the Equity Premium Puzzle: This chapter introduces regret theory, which suggests that individuals' decisions are influenced by the anticipation of potential future regret. It explains how regret aversion, the desire to avoid feeling regret, can lead to risk-averse behavior and, consequently, contribute to the EPP. The chapter connects regret theory to prospect theory and narrow framing, showing how the anticipation of regret can amplify the effects of loss aversion. A formal model is presented, illustrating the mathematical underpinnings of regret theory and demonstrating how it can explain the EPP. The integration of these behavioral factors provides a nuanced understanding of decision-making under uncertainty within financial markets.
Schlüsselwörter (Keywords)
Equity Premium Puzzle, Prospect Theory, Mental Accounting, Myopic Loss Aversion, Regret Theory, Behavioral Finance, Asset Pricing, Risk Aversion, Expected Utility Theory, Investor Behavior.
Frequently Asked Questions: A Behavioral Finance Perspective on the Equity Premium Puzzle
What is the main topic of this text?
This text explores behavioral explanations for the Equity Premium Puzzle (EPP), a discrepancy between the observed returns of stocks and bonds and the predictions of traditional financial models. It focuses on how deviations from standard expected utility theory, particularly prospect theory, mental accounting, and regret theory, can account for this anomaly.
What is the Equity Premium Puzzle (EPP)?
The EPP refers to the consistently higher returns observed for stocks compared to bonds over the long term, a phenomenon not fully explained by traditional financial models that assume rational investor behavior. The text investigates this discrepancy in detail.
What are the key behavioral finance theories discussed in relation to the EPP?
The text examines three key behavioral finance theories: Prospect Theory (with its value and weighting functions), Mental Accounting (how individuals categorize and treat money), and Regret Theory (the impact of anticipated regret on decisions). It explores how these theories, individually and in combination, can contribute to the EPP.
How does Prospect Theory explain the EPP?
Prospect Theory posits that individuals are more sensitive to losses than gains and overweight small probabilities. This implies that investors may be overly averse to the risk of stock market losses, leading to lower demand and higher returns for stocks to compensate for this risk aversion.
What is the role of Mental Accounting in the EPP?
Mental Accounting describes how individuals categorize and treat their finances. This can lead to different risk tolerances for various accounts (e.g., retirement versus everyday spending), potentially influencing investment decisions and contributing to the EPP.
How does Myopic Loss Aversion contribute to the EPP?
Myopic loss aversion, a combination of prospect theory and mental accounting, focuses on short-term losses and underweights long-term gains. This short-sighted focus can increase risk aversion, further explaining the higher returns needed to attract investment in equities.
What is Regret Theory, and how does it relate to the EPP?
Regret Theory suggests that the anticipation of future regret influences decisions. Individuals might avoid stocks to avoid potential regret from losses, even if the long-term expected return is higher. This regret aversion contributes to the EPP.
What are the chapter summaries provided in the text?
The text provides chapter summaries detailing the introduction to the EPP, a detailed explanation of the puzzle itself, thorough explorations of Prospect Theory and Mental Accounting, an examination of Myopic Loss Aversion and its application to the EPP, and finally, a detailed look into Regret Theory and its contribution to the EPP. Each summary highlights the key concepts and findings of each chapter.
What are the overall objectives and key themes of this text?
The main objective is to explore behavioral explanations for the EPP. Key themes include the limitations of traditional asset pricing models, the application of prospect theory, mental accounting, and regret theory to finance, the role of investor behavior in asset pricing, and a comprehensive explanation of the EPP itself.
What are the keywords associated with this text?
The keywords include Equity Premium Puzzle, Prospect Theory, Mental Accounting, Myopic Loss Aversion, Regret Theory, Behavioral Finance, Asset Pricing, Risk Aversion, Expected Utility Theory, and Investor Behavior.
- Citation du texte
- Kevin Rink (Auteur), 2010, Behavioral Explanation of the Equity Premium Puzzle, Munich, GRIN Verlag, https://www.grin.com/document/149884
