Equity Premium Puzzle

Question 1

What is the non behavioural explanations for the extreme risk aversion? 3

Answer 1

• equity premiums might be a rational response to the risk of an economic catastrophe, because bonds protect the capital investment better than equity (Reitz)
• maybe investors are a lot more risk averse than they used to be (Ceccheti)
• survivorship bias

Question 2

What is habit formation?

Answer 2

• people become averse to reductions in their consumption a, and this may explain the equity premium puzzle
• people don’t want to be left behind (so there is high return and Low asset prices)

Question 3

What are the behavioural explanations of the equity premium puzzle?

Answer 3

-loss aversion:unlike binds, annual stock returns are frequently negative (but only in short term)-can’t explain ERP in long term

Question 4

What is myopic loss aversion (debondt and Thaler)?

Answer 4

-combinations of loss aversion and short evaluation period makes investors unwilling to beat the risks associated with holding equities (so they demand higher equity premiums)
Investors look at their losses before the end of investment period (they don’t like to see short term variability even though this won’t hurt them in the long run)

Question 5

What is disappointment aversion?

Answer 5

Expectations can lead to greater disappointment

This is better explanations of ERP because it considers different time horizons

Question 6

What is equity risk premium?

Answer 6

Excess return that is provided over the risk free rare

But research shows that there is extreme risk aversion!