Behavioral Finance Rationality and Psychology February 26, 2008 Behavioral Finance “Rationality and Psychology” – Part IV – The Equity Premium Puzzle and other matters Economics 437

Behavioral Finance Rationality and Psychology February 26, 2008 Time Inconsistency (from prior lecture) People like tax refunds (implies a negative discount rate) People buy the cheaper durable (even though more expensive saves more energy, etc in future costs) implies a high positive discount rate Pre-commit to some future event (because you know you won’t do it otherwise)…the you today is not the you tomorrow

Behavioral Finance Rationality and Psychology February 26, 2008 Mental Accounting Lying on the beach ordering a beer From a nearby resort From a run-down country grocery store Credit cards Separate purchase from payment Blend item into larger overall costs Spending a windfall $ 500 tax refund versus $ 500 winning the office football pool

Behavioral Finance Rationality and Psychology February 26, 2008 The Equity Premium Puzzle Since 1926 (statement made in 1995 by Benartzi and Thaler) Real return of stocks is 7 percent Real return of treasury bills is less than 1 percent Requires investors to be extremely risk averse 50 % chance of $ 50,000 and $ 100,00 Equivalent to $ 51,209

Behavioral Finance Rationality and Psychology February 26, 2008 Merton - Samuelson Should short term investors prefer less equity (and more debt) than longer term investors Merton and Samuelson showed that there should be no difference Actual behavior seems to correspond to the Merton Samuelson result But, this is a “planning” point of view

Behavioral Finance Rationality and Psychology February 26, 2008 Prospect theory (Kahneman Tversky) Values gains less (in absolute value) than losses (loss aversion) As opposed to risk (variance) aversion Uses reference points (gains or losses from a particular vantage point

Behavioral Finance Rationality and Psychology February 26, 2008 End