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

  • Nicholas Barberis
  • Ming Huang

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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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
Note: AP
Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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