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The Equity Premium Puzzle Revisited (by the Behavioralists)

The Equity Premium Puzzle Revisited (by the Behavioralists). Economics 437. Barberis and Huang, April, 2006 “The Loss Aversion/Narrow Framing Approach to the Equity Premium Puzzle”. Nicholas Barberis, Prof of Economics, Yale Teaches course on Behavioral Finance at Yale

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The Equity Premium Puzzle Revisited (by the Behavioralists)

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  1. The Equity Premium Puzzle Revisited (by the Behavioralists) Economics 437

  2. Barberis and Huang, April, 2006“The Loss Aversion/Narrow Framing Approach to the Equity Premium Puzzle” • Nicholas Barberis, Prof of Economics, Yale • Teaches course on Behavioral Finance at Yale • Barberis is a “dyed in the wool” behavioralist

  3. The “Mehra Prescott” Problem • The very high equity premium, 4.6% in MP, 1985 is not consistent with • Most reasonable estimates of risk aversion (it implies extremely high risk aversion on the part of market participants) • Yet, attitudes toward large gambles, would suggest very low equity premiums • So, can the answer be found by introducing a new utility function that can somehow reconcile these matters?

  4. Consider the following: • Choice 1 • A. Sure gain of $ 240 • B. 25% chance of $ 1,000 and 75% chance of zero • Choice 2 • A. Sure loss of $ 750 • B. 75% chance to lose $ 1,000 and 25% chance to lose nothing

  5. Most people choose A, D • Choice 1 • A. Sure gain of $ 240 • B. 25% chance of $ 1,000 and 75% chance of zero • Choice 2 • C. Sure loss of $ 750 • D. 75% chance to lose $ 1,000 and 25% chance to lose nothing But A & D mean 25% chance to win $ 240 and 75% chance to lose $ 760 B& C mean 25% chance to win $ 250 and 75% chance to lose $ 750

  6. Choosing B & C means • Narrow Framing • Each choose was treated independently (not in a combined fashion) • MPT treats choices as “combined” not independently • Suppose losses in stocks are treated differently than losses in other parts of wealth • Could this explain the equity premium puzzle but also explain reasonable risk attitudes toward large gambles?

  7. Imagine the following utility function Up to the plus sign, this is a pretty typical utility function After the plus sign: stock market Gains and Losses Enter the picture With v rising more slowly with gains, falling much quicker with losses

  8. Condition L • An individual with wealth of $ 75,000 should not pay a premium higher than $ 15,000 to avoid a 50:50 chance of losing or gaining $25,000 • Most utility functions that satisfy this condition will lead to very small equity risk premiums • The utility function early will normally satisfy this condition as well as be consistent with 4.6% equity risk premiums.

  9. What Causes Narrow Framing? • Regret • We will remember that specific stock loss • Accessibility • We are just too lazy to combine things • These lead to different time patterns

  10. Review for Final • All Readings All Lectures • Three Main Themes • Noise Trading and Limits to Arbitrage • Anomalies • Serial Correlation • Final will also cover lectures since 2nd mid term • Written as a two hour final, but you will have three hours

  11. End

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