Behavioral Finance Prospect Theory Equity Premium Puzzle April 26, 2007 The Equity Premium Puzzle Revisited (by the Behavioralists) Economics 437

Behavioral Finance Prospect Theory Equity Premium Puzzle April 26, 2007 Barberis and Huang, April, 2006 “The Loss Aversion/Narrow Framing Approach to the Equity Premium Puzzle” Nicholas Barberis, Prof of Economics, Yale Teaches course on Behavioral Finance at Yale Barberis is a “dyed in the wool” behavioralist

Behavioral Finance Prospect Theory Equity Premium Puzzle April 26, 2007 The “Mehra Prescott” Problem The very high equity premium, 4.6% in MP, 1985 is not consistent with Most reasonable estimates of risk aversion (it implies extremely high risk aversion on the part of market participants) Yet, attitudes toward large gambles, would suggest very low equity premiums So, can the answer be found by introducing a new utility function that can somehow reconcile these matters?

Behavioral Finance Prospect Theory Equity Premium Puzzle April 26, 2007 Consider the following: Choice 1 A. Sure gain of $ 240 B. 25% chance of $ 1,000 and 75% chance of zero Choice 2 A. Sure loss of $ 750 B. 75% chance to lose $ 1,000 and 25% chance to lose nothing

Behavioral Finance Prospect Theory Equity Premium Puzzle April 26, 2007 Most people choose A, D Choice 1 A. Sure gain of $ 240 B. 25% chance of $ 1,000 and 75% chance of zero Choice 2 C. Sure loss of $ 750 D. 75% chance to lose $ 1,000 and 25% chance to lose nothing But A & D mean 25% chance to win $ 240 and 75% chance to lose $ 760 B& C mean 25% chance to win $ 250 and 75% chance to lose $ 750

Behavioral Finance Prospect Theory Equity Premium Puzzle April 26, 2007 Choosing B & C means Narrow Framing Each choose was treated independently (not in a combined fashion) MPT treats choices as “combined” not independently Suppose losses in stocks are treated differently than losses in other parts of wealth Could this explain the equity premium puzzle but also explain reasonable risk attitudes toward large gambles?

Behavioral Finance Prospect Theory Equity Premium Puzzle April 26, 2007 Imagine the following utility function Up to the plus sign, this is a pretty typical utility function After the plus sign: stock market Gains and Losses Enter the picture With v rising more slowly with gains, falling much quicker with losses

Behavioral Finance Prospect Theory Equity Premium Puzzle April 26, 2007 Condition L An individual with wealth of $ 75,000 should not pay a premium higher than $ 15,000 to avoid a 50:50 chance of losing or gaining $25,000 Most utility functions that satisfy this condition will lead to very small equity risk premiums The utility function early will normally satisfy this condition as well as be consistent with 4.6% equity risk premiums.

Behavioral Finance Prospect Theory Equity Premium Puzzle April 26, 2007 What Causes Narrow Framing? Regret We will remember that specific stock loss Accessibility We are just too lazy to combine things These lead to different time patterns

Behavioral Finance Prospect Theory Equity Premium Puzzle April 26, 2007 Review for Final All Readings All Lectures Three Main Themes Noise Trading and Limits to Arbitrage Anomalies Serial Correlation Final will also cover lectures since 2 nd mid term Written as a two hour final, but you will have three hours

Behavioral Finance Prospect Theory Equity Premium Puzzle April 26, 2007 End