Lecture 7: Equity Premium Puzzle Flashcards
(12 cards)
What is the Equity Premium Puzzle (EPP)?
The historical excess return of stocks over risk-free assets is too large to be explained by standard models of risk aversion.
Who introduced the term “Equity Premium Puzzle”?
Mehra and Prescott (1985)
What is the historical average equity premium in the U.S.?
Around 6% per year
Why is this a puzzle under standard finance theory?(EPP)
Standard consumption-based models require implausibly high risk aversion to justify observed premiums.
What level of risk aversion is needed to explain the historical premium?
Relative risk aversion (RRA) > 10, which contradicts microeconomic evidence (typical RRA ≈ 1–3)
What does the EPP challenge in finance?
The validity of the standard Expected Utility Model and rational representative agent assumptions.
Name one behavioral explanation for the EPP.
Loss aversion combined with narrow framing (Benartzi & Thaler, 1995)
What is narrow framing in the context of the EPP?
Evaluating risky investments in isolation rather than as part of a broader portfolio, making losses more salient.
How does loss aversion help explain the EPP?
Investors require a large premium to accept the risk of short-term losses, even when the long-term gain is positive.
What empirical evidence supports a behavioral view of the EPP?
Myopic loss aversion experiments, surveys showing excessive fear of short-term losses, short evaluation horizons despite long-term investments.
What is “myopic loss aversion”?
Investors are loss averse and check their portfolios too frequently, leading to an exaggerated perception of risk.
What role does framing play in the EPP?
Investors’ evaluation frames (e.g., monthly vs. yearly performance) affect perceived risk and required returns.
