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The Loss Aversion / Narrow Framing Approach to the Equity Premium Puzzle

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  • Nicholas Barberis
  • Ming Huang
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    Abstract

    We review a recent approach to understanding the equity premium puzzle. The key elements of this approach are loss aversion and narrow framing, two well-known features of decision-making under risk in experimental settings. In equilibrium, models that incorporate these ideas can generate a large equity premium and a low and stable risk-free rate, even when consumption growth is smooth and only weakly correlated with the stock market. Moreover, they can do so for parameter values that correspond to sensible attitudes to independent monetary gambles. We conclude by suggesting some possible directions for future research.

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    File URL: http://www.nber.org/papers/w12378.pdf
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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12378.

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    Date of creation: Jul 2006
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    Publication status: published as Mehra, R. (ed.) Handbook of the Equity Risk Premium. Elsevier Science, 2008.
    Handle: RePEc:nbr:nberwo:12378

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    Cited by:
    1. Schilirò, Daniele, 2012. "Bounded rationality: psychology, economics and the financial crisis," MPRA Paper 40280, University Library of Munich, Germany.
    2. Guiso, Luigi, 2009. "A test of narrow framing and its origin," CEPR Discussion Papers 7112, C.E.P.R. Discussion Papers.
    3. Marie-Hélène Broihanne & Maxime Merli & Patrick Roger, 2008. "A Behavioural Approach To Financial Puzzles," Working Papers of LaRGE Research Center 2008-01, Laboratoire de Recherche en Gestion et Economie (LaRGE), Université de Strasbourg.
    4. Fernandez, Pablo & Aguirreamalloa, Javier & Liechtenstein, Heinrich, 2009. "The equity premium puzzle: High required equity premium, undervaluation and self fulfilling prophecy," IESE Research Papers D/821, IESE Business School.
    5. Dillenberger, David, 2008. "Preferences for One-Shot Resolution of Uncertainty and Allais-Type Behavior," MPRA Paper 8342, University Library of Munich, Germany.
    6. Nicholas Barberis & Ming Huang & Richard H. Thaler, 2006. "Individual Preferences, Monetary Gambles, and Stock Market Participation: A Case for Narrow Framing," American Economic Review, American Economic Association, vol. 96(4), pages 1069-1090, September.
    7. David Dillenberger, 2008. "Preferences for One-Shot Resolution of Uncertainty and Allais-Type Behavior," PIER Working Paper Archive 08-036, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.

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