Package 1 Flashcards
The U.S. Equity Return Premium: Past,
Present, and Future
Equity Premium Puzzle:
The phenomena that describes the anomaly higher historical real returns than stocks of the government bonds
The U.S. Equity Return Premium: Past,
Present, and Future
Explanations of EPP
• Behavioral finance: myopia, loss aversion, ambiguity aversion and
other biases
• Lower tail risk (in reality stocks are less affected by lower tail risk
than bonds), low-probability events (the Great Depression)
• Transaction costs & borrowing costs
• Consumption risks
• Previous misconceptions and learning effect – according to it, in the future there won’t be equity puzzle
The U.S. Equity Return Premium: Past,
Present, and Future
Why Risk Aversion doesn’t explain EPP
- “stock returns do not covary enough
with current consumption and lifetime wealth to
justify the substantial risk aversion” - high equity premium might mean high
risk aversion, BUT then we have a puzzle “why
the risk-free is so low”?
The U.S. Equity Return Premium: Past,
Present, and Future
The future of the puzzle
• Equity premium will remain as investors have
the same behavioral biases
• OR Premium will decrease (from 6% to 4%)
The U.S. Equity Return Premium: Past,
Present, and Future
Why the premium could decrease in the future?
– Institutional changes
– Accessibility of diversification
– Ease of investing
– Increasing number of market participants
From Efficient Markets Theory to
Behavioral Finance
Feedback model(explain)
(Speculative) prices go up → public attention →
demand up → prices go up → … bubble
From Efficient Markets Theory to
Behavioral Finance
Feedback model - examples
Tulip Mania
Dot.com bubble
Ponzi schemes
From Efficient Markets Theory to
Behavioral Finance
Biased self-attribution
• Good events happen because I am smart,
skillful
• Bad events happen because of bad luck,
sabotage and failure of others
From Efficient Markets Theory to
Behavioral Finance
Efficient market hypothesis
The theory that beating the market is imposible
From Efficient Markets Theory to
Behavioral Finance
What is Behavioral Finance
Behavioral finance - that is, finance from a broader social science perspective including psychology and sociology.
From Efficient Markets Theory to
Behavioral Finance
Explain Paul Samuelson’s statement the stock market that is “micro efficient but macro inefficient”
since there is considerable predictable variation across firms in their predictable future paths of dividends but little predictable variation in aggregate dividends
From Efficient Markets Theory to
Behavioral Finance
Smart money
The group investors who doesn’t going in the same direction than the mass does.
They predict bubble and start to short it.
Play against the market.
From Efficient Markets Theory to
Behavioral Finance
Supporting evidence for feedback model
o World of mouth
o Human judgments
o Biased self-attention
o Model of demand for a speculative asset
From Efficient Markets Theory to
Behavioral Finance
Smart money vs ordinary investment
- Smart money or “marginal trader” can offset the foolishness of many investors and make market efficient
- There are momentum investors, who buys after prices were rising
- Stock is more expensive to short tended to be overpriced
From Efficient Markets Theory to
Behavioral Finance
Reasons why EMH might be incorrect:
- All investors view information differently
- Stocks take time to respond familiar information
- Stock prices might be effected by human error
- Investors can take a profit from the market anomalies
