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Myopic Loss Aversion and the Equity Premium Puzzle

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  • Shlomo Benartzi
  • Richard H. Thaler

Abstract

The equity premium puzzle, first documented by Mehra and Prescott, refers to the empirical fact that stocks have greatly outperformed bonds over the last century. As Mehra and Prescott point out, it appears difficult to explain the magnitude of the equity premium within the usual economics paradigm because the level of risk aversion necessary to justify such a large premium is implausibly large. We offer a new explanation based on Kahneman and Tversky's 'prospect theory'. The explanation has two components. First, investors are assumed to be 'loss averse' meaning they are distinctly more sensitive to losses than to gains. Second, investors are assumed to evaluate their portfolios frequently, even if they have long-term investment goals such as saving for retirement or managing a pension plan. We dub this combination 'myopic loss aversion'. Using simulations we find that the size of the equity premium is consistent with the previously estimated parameters of prospect theory if investors evaluate their portfolios annually. That is, investors appear to choose portfolios as if they were operating with a time horizon of about one year. The same approach is then used to study the size effect. Preliminary results suggest that myopic loss aversion may also have some explanatory power for this anomaly.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4369.

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Date of creation: May 1993
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Publication status: published as Quarterly Journal of Economics, February 1995.
Handle: RePEc:nbr:nberwo:4369

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  1. Mankiw, N.G. & Zeldes, S.P., 1990. "The Consumption Of Stockholders And Non-Stockholders," Weiss Center Working Papers, Wharton School - Weiss Center for International Financial Research 23-90, Wharton School - Weiss Center for International Financial Research.
  2. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 22(1), pages 133-136, July.
  3. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, MIT Press, vol. 51(3), pages 247-57, August.
  4. Kahneman, Daniel & Knetsch, Jack L & Thaler, Richard, 1986. "Fairness as a Constraint on Profit Seeking: Entitlements in the Market," American Economic Review, American Economic Association, American Economic Association, vol. 76(4), pages 728-41, September.
  5. Wayne E. Ferson & George M. Constantinides, 1991. "Habit Persistence and Durability in Aggregate Consumption: Empirical Tests," NBER Working Papers, National Bureau of Economic Research, Inc 3631, National Bureau of Economic Research, Inc.
  6. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, Springer, vol. 5(4), pages 297-323, October.
  7. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 15(2), pages 145-161, March.
  8. Keim, Donald B., 1983. "Size-related anomalies and stock return seasonality : Further empirical evidence," Journal of Financial Economics, Elsevier, Elsevier, vol. 12(1), pages 13-32, June.
  9. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, Elsevier, vol. 22(1), pages 117-131, July.
  10. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers, National Bureau of Economic Research, Inc 2829, National Bureau of Economic Research, Inc.
  11. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive, David K. Levine 1397, David K. Levine.
  12. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, MIT Press, vol. 51(3), pages 239-46, August.
  13. Kahneman, Daniel & Knetsch, Jack L & Thaler, Richard H, 1990. "Experimental Tests of the Endowment Effect and the Coase Theorem," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 98(6), pages 1325-48, December.
  14. Pratt, John W & Zeckhauser, Richard J, 1987. "Proper Risk Aversion," Econometrica, Econometric Society, Econometric Society, vol. 55(1), pages 143-54, January.
  15. Hovenkamp, Herbert, 1991. "Legal Policy and the Endowment Effect," The Journal of Legal Studies, University of Chicago Press, University of Chicago Press, vol. 20(2), pages 225-47, June.
  16. Samuelson, William & Zeckhauser, Richard, 1988. " Status Quo Bias in Decision Making," Journal of Risk and Uncertainty, Springer, Springer, vol. 1(1), pages 7-59, March.
  17. L. Epstein & S. Zin, 2010. "First order risk aversion and the equity premium puzzle," Levine's Working Paper Archive, David K. Levine 1400, David K. Levine.
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  1. Thinking in Foreign Language Makes Decisions More Rational
    by Brandon Keim in Wired Science on 2012-04-24 20:41:49
  2. Present Value Analysis - Fundamentals
    by Financewonk in The Finance Wonk on 2006-05-25 12:00:00
  3. Thinking in a Foreign Language
    by Venkat in Tempo on 2012-04-26 18:33:58
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