Equity Premium

Question 1

What are the properties of the Value function in prospect theory?

Answer 1

1) Loss aversion - more scared of losing money than getting it
2) Diminishing sensitivity (risk aversion to gains, risk loving to losses)
3) Reference point V(0)=0

Question 2

What is the equity premium puzzle?

Answer 2

That equity premium on taking risk is far too large whilst the return on ‘risk-free’ isn’t high enough

Question 3

What did Mehra and Prescott find? (1985)

Answer 3

Their theory suggests that alpha (measure of risk aversion) should hover around 1, but in fact it came to between 30-40

Question 4

How are equities mean reverting and T-bills mean averting?

Answer 4

After a year when returns fall, they rebound whilst T-bills fall further the following year. Return to equity is more stable over 20 year period.

Question 5

What is Myopic loss aversion?

Answer 5

It describes how frequency of checking portfolio performance affects risk, the more often a person checks, the less equity they hold. 12 months minimum evaluation period to explain the equity premium.

Question 6

What evidence is there to support Myopic loss aversion?

Answer 6

Thaler et al. (1997), found that subjects who could check every year or 5 years were more heavily invested in stocks whereas the monthly checkers were predominantly in bonds.

Question 7

What is habit formation?

Answer 7

People consume at a certain level out of habit, in context of investment, investors are highly risk averse in short run but less so in long-run.

Question 8

What is the argument for extreme risk aversion?

Answer 8

Consumers are extremely averse to small

negative consumption shocks due to the idea consumers live in morbid fear of recessions