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Myopic loss aversion, disappointment aversion, and the equity premium puzzle

  • Fielding, David
  • Stracca, Livio

This paper takes a close look at the 'behavioural finance' explanations of the equity premium puzzle, namely myopic loss aversion (Benartzi and Thaler, 1995) and disappointment aversion (Ang, Bekaert and Liu, 2000). The paper proposes a simple specification of loss and disappointment aversion and brings these theories to the data. The main conclusion of the paper is that a highly short-sighted investment horizon is required for the historical equity premium to be explained by loss aversion, while reasonable values for disappointment aversion are found also for long investment horizons. So, stocks may lose only in the short term, but may disappoint also in the long term. JEL Classification: G11, G12

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Paper provided by European Central Bank in its series Working Paper Series with number 0203.

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Date of creation: Jan 2003
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Handle: RePEc:ecb:ecbwps:20030203
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  1. Otrok, C. & Ravikumar, B. & Whiteman, C., 1998. "Habit Formation: A Resolution of the Equity Premium Puzzle?," Working Papers 98-04, University of Iowa, Department of Economics.
  2. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  3. Matthew Rabin, 2001. "Risk Aversion and Expected-Utility Theory: A Calibration Theorem," Method and Hist of Econ Thought 0012001, EconWPA.
  4. Frankfurter, George M. & McGoun, Elton G., 2002. "Resistance is futile: the assimilation of behavioral finance," Journal of Economic Behavior & Organization, Elsevier, vol. 48(4), pages 375-389, August.
  5. Nicholas Barberis, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," Journal of Finance, American Finance Association, vol. 56(4), pages 1247-1292, 08.
  6. Ang, Andrew & Bekaert, Geert & Liu, Jun, 2005. "Why stocks may disappoint," Journal of Financial Economics, Elsevier, vol. 76(3), pages 471-508, June.
  7. George M. Constantinides & John B. Donaldson & Rajnish Mehra, 2002. "Junior Can't Borrow: A New Perspective on the Equity Premium Puzzle," The Quarterly Journal of Economics, Oxford University Press, vol. 117(1), pages 269-296.
  8. Jia, Jianmin & Dyer, James S & Butler, John C, 2001. "Generalized Disappointment Models," Journal of Risk and Uncertainty, Springer, vol. 22(1), pages 59-78, January.
  9. Tversky, Amos & Kahneman, Daniel, 1992. "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
  10. John H. Cochrane, 1997. "Where is the market going? Uncertain facts and novel theories," Economic Perspectives, Federal Reserve Bank of Chicago, issue Nov, pages 3-37.
  11. Nicholas Barberis & Ming Huang & Tano Santos, 1999. "Prospect Theory and Asset Prices," NBER Working Papers 7220, National Bureau of Economic Research, Inc.
  12. Jeremy J. Siegel & Richard H. Thaler, 1997. "Anomalies: The Equity Premium Puzzle," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 191-200, Winter.
  13. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  14. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
  15. Brown, Stephen J & Goetzmann, William N & Ross, Stephen A, 1995. " Survival," Journal of Finance, American Finance Association, vol. 50(3), pages 853-73, July.
  16. Nicholas Barberis & Ming Huang, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," NBER Working Papers 8190, National Bureau of Economic Research, Inc.
  17. Tversky, Amos & Kahneman, Daniel, 1986. "Rational Choice and the Framing of Decisions," The Journal of Business, University of Chicago Press, vol. 59(4), pages S251-78, October.
  18. L. Epstein & S. Zin, 2010. "First order risk aversion and the equity premium puzzle," Levine's Working Paper Archive 1400, David K. Levine.
  19. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
  20. George M. Constantinides, 2002. "Rational Asset Prices," NBER Working Papers 8826, National Bureau of Economic Research, Inc.
  21. Rajnish Mehra, 2003. "The Equity Premium: Why is it a Puzzle?," NBER Working Papers 9512, National Bureau of Economic Research, Inc.
  22. Charles Goodhart & Margaret Bray, 2002. "You Might as Well be Hung for a Sheep as a Lamb: The Loss Function of an Agent," FMG Discussion Papers dp418, Financial Markets Group.
  23. Eugene F. Fama & Kenneth R. French, 2002. "The Equity Premium," Journal of Finance, American Finance Association, vol. 57(2), pages 637-659, 04.
  24. Gul, Faruk, 1991. "A Theory of Disappointment Aversion," Econometrica, Econometric Society, vol. 59(3), pages 667-86, May.
  25. Shlomo Benartzi & Richard H. Thaler, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 73-92.
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