06. Equity Premium Flashcards
What is the equity premium?
Historically there have been enormous discrepancy between returns on stocks and fixed income securities.
Mehra & Prescott (1985): US stocks outperformed US short term corporate bonds in almost a century by about 7% per year.
This is the equity premium = difference in the rate of return on equities and a safe investment like treasure bills.
What is the classic finance theory explanation for the equity premium?
The more volatile a financial instrument/asset is, the higher the expected return. In order to compensate investors for bearing the risk associated with movements in the price = compensating for the risk of the volatility of the asset.
Equity premium puzzle: why is the demand for governement bonds as high as it is given the relative lower return.
It is well known that stocks are much more volatile than bonds, so is it actually a puzzle and why?
Can the premium be explained by risk aversion?
Could risk aversion help to explain the historical equity premiuM?
Risk aversion important: some premium to be expected.
Coefficient of relative risk aversion: a measure of risk aversion. Previous estimates and theory suggest a factor 2-4.
Mehra and Prescott (1985) demonstrate: high equity premium is difficult to reconcile with plausible levels of risk aversion by investors.
Coefficient of relative risk aversion in excess of 30 to explain historical equity premium -> this is insanely high.
What is the explanation of Bernatzi & Thaler (1995)?
Explain equity premium puzzle by 2 features of prospect theory: loss aversion & mental accounting = myopic loss aversion.
Bernatzi & Thaler: “Risk attitude of loss averse investors depends upon frequency with which they close their accounts and reset their reference point”.
Decisions depend upon how long a certain mental account remains open or how often eg evaluates the gains and losses of one’s investments.
Mental accounts and mental accounting.
What are mental accounts?
Mental accounts: “an outcome frame which specifies (a) the set of elementary outcomes that are evaluated jointly, (b) the manner in which they are combined and (c) a reference outcome that is considered neutral or normal.
People sete up and work with mental accounts for different transactions.
Mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate and keep track of their financial activities
What is dynamic mental accounting?
Three aspects:
1) How uncertain prospects are perceived, coded and experienced
2) The assignment of activities to specific accounts
3) The frequency with which accounts are evaluated.
Choices are altered by introduction of notional (but non-fungible) boundaries.
Location of boundaries matters in mental accounting
Boundaries are also set when we decide whether a series of decisions are made one at a time or grouped together (or bracketed) = dynamic mental accounting
What did Kahneman and Tversky discover about betting on races?
Kahneman and Tversky mention empirical finding that betting on long shots increases on the last race of the day, when the average bettor is:
1) Losing money on the day
2) Anxious to break even
This effect totally depends on decision to close betting account daily.
If each race was a separate account, prior races would have no effect, and similarly if today’s betting were combined with the rest of the bettor’s wealth (or even his lifetime of bets) –> prior outcomes would likely be trivial.
The racing day is a natural bracket. Gambles or investments occur over a period of time = giving the decision-maker considerable flexibility in how often to calculate gains and losses.
The unconcious choice of how to bracket the gambles influences the attractiveness of the individual bets.
Loss-averse people are more willing to take risks if they combine many bets together = than if they consider them one at a time.
What did Bernatzi & Thaler (1995) investigate?
Risk attitude of loss-averse investors depends on the frequency with which they evaluate their investments.
Starting point: investors have prospect theory preferences.
They ask: how often peole would have to evaluate the changes in their portfolios to make them indifferent between the (US) historical distributions of returns on stocks & bonds? Where is the point of indifference where they don’t want to hold stocks anymore.
What are the conclusions from simulations of Bernatzi & Thaler?
Question answered through simulations using historical stock and bond returns.
The conclusions drawn from the simulations are:
1) The evaluation period which makes people indifferent between a pure stock and a pure bond portfolio is between 10 and 13 months for real and nominal returns respectively.
2) Given this evaluation period: optimal allocation between stocks and bonds is in the interval from 20-50 percent in stocks.
What did Gneezy and Potters investigate?
2003: Does the frequency of information feed-back and the flexibility of portfolio adjustment affect asset prices?
Test of the consequences of the theory
Aim: test whether effects of myopic loss aversion shows up in a competitive environment.
Experimental markets in which traders adjust portfolios by buying and selling a risky financial asset.
1) High-frequency treatment: traders commit investments for one period, and are informed about assets’ returns after each period
2) Low-frequency treatment: they commit investments for 3 periods, and are informed about the assets’ returns only after 3 periods.
What is the hypothesis of Gneezy & Potters?
Prices of risky asset in low frequency treatment significantly higher than in high grequency treatment
What is the experimental design of Gneezy & Potters?
Participants trade units of risky assets in a sequence of 15 trading periods.
Each unit consists of a lottery ticket has a 1/3 chance of paying 150 cents, and a 2/3 chance of paying 0 cents.
Each trader is endowed with 200 cents and 3 tickets a the beginning of each period
Each period can buy and/or sell tickets at the beginning of each period.
Two treatments: high and low frequency:
1) In high frequency treatment: market opents in each period, and participants can adjust their portfolio
2) Low frequency: market is open only in the first period in a block of 3 periods = the portfolio is constant in those three periods
What are the results of the Gneezy and Potters?
Hypothesis: information feedback and portfolio adjustment is higher in the high frequency treatment, the authors expect the myopic loss averse traders to be less willing to hold assets leading to a lower price.
The authors find strong evidence that a high frequency of information feedback and greater degree of flexibility of portfolio adjustment leads to a lower price of a risky asset.
This is in line with myopic loss avesion, and counter to expected utility theory.
However, myopic loss aversion doesn’t explain the overpricing seen in the experiments.
Do professional traders exhibit behaviour in line with myopic loss aversion?
The Potters experiment was done with inexperienced subjects.
–> can this result be generalized to settings with informed and experienced market participants?
Observed treatment effects among students may not be representative of behaviour in naturally occuring environements, where selection effects may have created distinct populations of economic-decision makers.
To explore this issue: they make use of undergraduate students as a control group and recruit 54 professional traders from Chicageo Board of Trade: do behavioral discrepances exist across subject pools?
They find that professionals do indeed behave differently from undergraduate students.
But instead of displaying behaviour inconsistent with the MLA conjecture, the professional traders exhibit behaviour consistent with MLa to a greater extent than undergraduate students.
Wha else does the presence of MLA suggest?
Presence of MLA suggests that market prices of risky assets might be significantly higher if feedback frequency and decision flexibility are reduced.
This means: institutions may have the ability to influence asset prices through changes in their information provisioning policies.
Gneezy et al (2003): this behavioural phenomenon appears to be what compelled Israel’s largest mutual fund manager, Bank Hapoalim, to change its information release about fund performance from every month to every 3 months, noting that “investors should not be scared by the occasional drop in prices”.
