Lecture 5 - Equity Premium Puzzle, Excess Volatility, Bubbles and Crashes

What is equity risk premium?

the excess return of an individual stock or market over the risk-free rate

Why is there equity risk premium?

to compensate investors for taking on the higher risk of the equity market

Why can the equity risk premium not be reconcilled with investors risk aversion?

the equity risk premium of the market is too high for a reasonable level of risk aversion

What are 3 non-behavioural explanations for the equity risk premium?

1. equity risk premium is a rational response to economic catastrophe as bonds are better protected than equities

2. survivorship bias

3. habit formation (people are used to a certain standard of living hence asset prices are low and so returns are high to explain equity premium)

What are behavioural explanations of equity risk premium?

stocks often provide a negative return so we prefer high equity premium (a form of loss aversion)

Why does loss aversion not explain equity risk premium?

over longer horizons, equity returns arent likely to be negative meaning we must assume that investors focus on the short term

What are two psychological pieces of evidence about decision making?

1. loss aversion

2. mental accounting

What is myopic loss aversion?

This is a combination of loss aversion and a short evaluation period which makes investors unwilling to bear risks associated with equities (therefore higher ERP)

What did Bernartzi and Thaler say explained equity risk premium?

Peoples loss aversion and frequently evaluating wealth positions

why does frequently evaluating your wealth position result in equity risk premium?

losses are only realised at the end of an investment period (usually long) but frequently checking positions means investors are likely to see losses and more likely to close out a position early

What is the evidence of Myopic loss aversion?

people who have less information feedback evaluate investment in more aggregated ways

How myopic does an investor have to be before loss aversion no longer holds?

beyond 3 years it no longer holds

What is an example of disappointment aversion?

A lottery with a higher certainty equivalence is not always better, since higher expectations can lead to greater disappointment

What is the excess volatility puzzle?

Asset price volatility are too high to be explained by fundamentals such as earnings and dividends

how can excess volatility puzzle be explained?

some variations can be attributed to news but most can be explained by raitonal variations in discount rates

how do bubbles/crashes disprove the rational view of the market?

markets can’t be efficient or rational if there is blind selling and buying not based on any fundamentals

what is the rational perspective on bubbles and crashes?

changes in underlying fundamentals can elad to a large change in stock prices