NAME: ROSHAN KOVILAPATI REG NUM:20BEE0057

DIGITAL ASSIGNMENT – 2
BEHAVIOURAL ECONOMICS
HUM 1046

Case 6.1 The equity premium puzzle

The equity premium puzzle (EPP) is that over the long-term stocks have consistently outperformed
bonds by a large margin. It is certainly one of the most hotly debated topics in fi nancial economics.
The debate was largely sparked off by a paper by Mehra and Prescott (1985). They reported that, on
the basis of US data for about 100 years from 1889–1978, the average annual real return to stock
was 7%, while the average annual return to Treasury bills was 1%, indicating a risk premium
between risky and safe assets of about 6%. The authors claim that such a large premium is a puzzle
because, according to conventional economic models, it implies an astronomical coeffi cient of risk-
aversion, in excess of 30. In order to aid an interpretation of this value, Mankiw and Zeldes (1991)
provide an example: a person with such a degree of risk-aversion would be indifferent between a
gamble with a 50% chance of a consumption of $100,000 and a 50% chance of a consumption of
$50,000, and a certain consumption of $51,209. This does not seem reasonable in the light of other
empirical data. Furthermore, the puzzle does not seem confi ned to the US. A study by Canova and
De Nicoló (2003) fi nds that ‘the basic features of the equity premium and risk-free puzzles remain
regardless of the sample period and the country considered’ (p. 222). The risk-free puzzle can be
viewed as the converse of the EPP, as it poses the apparent anomaly of why the risk-free rate is so
low. At present investigators are divided into three main camps: those who do not believe that there
is a puzzle at all, those who have proposed some kind of explanation, and those who have reviewed
the different explanations, and believe that the puzzle remains. The purpose here is not to discuss all
these different approaches in any detail, but rather to focus on one particular explanation by
Benartzi and Thaler (1995), which involves the behavioral aspects of PT and mental accounting.
Before explaining this approach, however, it is worthwhile gaining an overall perspective by giving a
brief overview of the three main camps mentioned above. Those investigators who do not believe in
the existence of the puzzle point to various problems and ambiguities related to measurement.
Perhaps the most fundamental issue here is the distinction between the historical premium and the
expected or ex ante premium. Ibbotson and Chen (2003) estimate that the ex ante premium over
the period 1926–2000 in the US was about 1.25% lower than the historical premium. A second issue
relates to the choice of risk-free asset. Most studies use either treasury bills or long-term treasury
bonds, usually with a maturity of 20 years. Jones and Wilson (2005) estimate that over the period
1871–2003 the historical equity premium was 4.79% on bonds and 3.85% for bills. However, in
certain periods the difference has been much larger. In the period 1990–2003 the equity premium
was only 2.05% for bonds, but 6.32% for bills. Jones and Wilson also discuss a third measurement
issue: the use of geometric means versus arithmetic means. They use the former measure, on the
basis that they are more appropriate in a long-term time series study. The difference is notable;
Jones and Wilson estimate that arithmetic means, as used in the Mehra–Prescott study, tend to be
1.6%–1.8% higher than geometric means. A fi nal measurement issue concerns whether returns
should be described in nominal or real terms. Benartzi and Thaler (1995) argue that nominal
measures are often more appropriate, for two reasons: fi rst, returns are usually reported in nominal
terms; second, simulations suggest that investors cannot be thinking in real terms, otherwise they
would not be willing to hold treasury bills over any evaluation period, since they always yield
negative prospective utility. Although these measurement issues muddy the waters as far as
obtaining a precise measure of the size of the equity premium, most researchers still believe that the
historical premium is signifi cantly large. Over the last 20 years there have been many attempts to
explain the puzzle. Some of the better known models are: 1 Generalized expected utility (Epstein
and Zin, 1989; Weil, 1989). 2 Habit formation (Constantinides, 1990; Ferson and Constantinides,
1991; Hung and Wang, 2005; Meyer and Meyer, 2005). 3 Imperfect markets or market frictions (He
and Modest, 1995; Luttmer, 1996; Zhou, 1999). 4 Ambiguity or uncertainty (Olsen and Troughton,
2000; Aloysius, 2005). 5 Delayed consumption updating (Gabaix and Laibson, 2001). 6 Fluctuating
economic uncertainty or consumption volatility (Bansal and Yaron, 2004). Finally, there are a
considerable number of commentators who have surveyed the above models and results, and
conclude that the EPP is still a puzzle, for example, Kocherlakota (1996), Chapman (2002) and
Oyefeso (2006). The Benartzi and Thaler (BT) approach combines two important elements: 1 A utility
function described by PT, involving reference points, diminishing marginal sensitivity, a weighted
probability function, and loss-aversion. The authors note that this function has something in
common with the habit formation explanation, in that both models involve reference points. 2 A
mental accounting process whereby portfolios are evaluated at regular intervals, and accounts are
‘closed’. The authors then proceeded to ask two questions: 1 What evaluation period would
investors have to use in order to be indifferent between a portfolio consisting entirely of stocks and
a portfolio consisting entirely of 5-year treasury bonds? 2 Given the evaluation period determined
above, what combination of stocks and bonds would people hold in order to maximize prospective
utility? The authors based their answers to the above questions on simulations using historical data
for the US from 1926 to 1990 involving monthly returns on stocks, bonds and bills. They fi nd that
the evaluation period in the fi rst question was about 13 months, in terms of nominal returns, and
about 10 months for real returns. They then fi nd that the optimal position for investors involves 30–
55% of the portfolio invested in stock. The prospective utility function is virtually fl at over this
range. These results broadly match empirical fi ndings; institutional investors have about 53% of
their portfolios in stocks, while individuals allocate their funds between stocks and bonds on about a
50–50 basis. Having derived results to these two questions, the authors proceed to ask two further
questions: 1 Which aspects of PT drive the results? 2 How sensitive are the results to alternative
specifi cations? They fi nd that loss-aversion is the main determinant of the outcomes, whereas the
specifi c functional forms of the value function and weighting functions are not critical. When the
parameters in the model are changed in specifi cation this also does not appear to signifi cantly
affect the length of the evaluation period. For example, if actual probabilities are used instead of a
weighting function, the period is reduced by one or two months. The BT study also examines the
relationship between the equity premium and the length of evaluation period. They fi nd that the
premium falls from 6.5% for a one-year period to about 3% for a fi ve-year period, 2% for a ten-year
period and 1.4% for a 20-year period. The authors then comment that investors with a 20-year
horizon are able to reap the reward of an economic rent of 5.1% if they are able to resist the
temptation to count their money often: ‘in a sense, 5.1% is the price for excessive vigilance’. These
reduced premiums estimated by the BT study are matched by calculations by Jones and Wilson
(2005). The risks of loss in terms of investing in stocks rather than bonds are refl ected in the
probability of a negative premium for the period of evaluation. This probability is particularly
relevant in the BT model, which is driven strongly by loss-aversion. Jones and Wilson estimate that
the probability of a negative premium falls from 41% for a one-year period to 33% for a fi ve-year
period, 25% for a ten-year period and 17% for a 20-year period. The fi nal element in the BT paper
contains a solution to the puzzle of organizational myopic loss-aversion (MLA). While individuals may
be strongly tempted to count their money frequently, why should this apply to institutional investors
like pension funds who should have every reason to take a long-term evaluation period? The answer
given is that the reason for organizational MLA lies in an agency problem. The fund managers in such
institutions have to report results on an annual basis, and are held accountable for these short-term
results. Bearing in mind the competitive nature of these funds, there may be a ‘tragedy of the
commons’ here, in that managers may be tempted to trade-off better short-term results for better
long-term results, knowing that their rivals are in the same situation. Such game theory
considerations are discussed in Chapter 9.

Questions
1)Explain the statement: ‘In a sense, 5.1% is the price for excessive vigilance’.
A:This statement refers to the cost associated with constantly monitoring investments.
The 5.1% signifies the reduction in returns attributable to frequent portfolio
evaluation. It suggests that the act of continuously checking and readjusting
investments comes at a cost, impacting potential gains. Investors tempted to
frequently reassess their portfolios might sacrifice potential returns, represented by
this percentage. It reflects the trade-off between active management, which provides a
sense of control, and the potential detriment to long-term returns due to overactive
monitoring. Essentially, the 5.1% illustrates the "price" one pays for excessive
vigilance, highlighting the balance between active involvement and the erosion of
potential returns.
Investors who frequently check their portfolios may experience diminished
returns due to increased risk exposure associated with shorter evaluation periods. The
statement implies that there's an opportunity cost linked to being overly vigilant, as
investors might sacrifice potential long-term gains for short-term
reassurance.Excessive vigilance and constant portfolio checking might lead to
suboptimal investment decisions driven by short-term market noise rather than long-
term fundamentals. Consequently, the 5.1% figure serves as a representation of the
foregone returns resulting from this excessive attention to short-term fluctuations.
The statement underscores the importance of balancing vigilance and patience
in investment strategies. It suggests that a more patient, less vigilant approach might
yield higher long-term returns despite the allure of constant portfolio monitoring.

2)What is the signifi cance of the probability of a negative premium?

A: The probability of a negative premium denotes the risk associated with investing in
stocks over bonds during a specific evaluation period. In this context, it reflects the
chance that stocks might underperform compared to bonds over the given timeframe.
A higher probability of a negative premium indicates greater uncertainty and risk in
stock investments during that period. For instance, a 41% probability of a negative
premium for a one-year evaluation suggests a relatively high risk of stocks performing
worse than bonds over that year. This probability, particularly emphasized in the
Benartzi and Thaler (BT) model driven by loss-aversion, helps gauge the level of risk
investors face when choosing stocks over bonds within a specific timeframe.
A higher probability of a negative premium emphasizes the increased risk
exposure and potential financial losses that investors might face when choosing riskier
assets over a specified period. It signals the possibility of underperformance or
suboptimal returns in stock investments compared to safer alternatives. Understanding
the probability of a negative premium helps investors assess and quantify the level of
risk they undertake when allocating their investments. It aids in making informed
decisions about asset allocation and portfolio diversification strategies. Moreover, a
lower probability of a negative premium indicates a higher likelihood of positive
returns or outperformance in stock investments compared to less risky assets like
bonds within that particular evaluation period. This probability provides insights into
the potential outcomes and associated risks of different investment choices.
In summary, the significance of the probability of a negative premium lies in its
indication of the potential risks and downside possibilities in investing in stocks
relative to safer assets over a specific timeframe, aiding investors in evaluating risk
and making informed investment decisions.

3)Is the equity premium likely to remain at the historical level in the future?
A: Forecasting the equity premium's future trajectory is complex due to various
factors affecting financial markets. While historical data indicate a significant
premium, future trends might deviate. Economic shifts, market dynamics, regulatory
changes, or advancements in financial theories could influence this premium. Studies
since the BT analysis have explored diverse factors affecting the equity premium,
acknowledging its variability across different evaluation periods and asset types.
Future equity premiums may differ due to evolving market conditions, altered investor
behaviors, or improved understanding of risk factors. Therefore, while historical data
provide insights, accurately predicting the future level of the equity premium remains
challenging.

4)How have studies since the BT study of 1995 shed light on the phenomenon of
the equity premium puzzle and the MLA explanation?
A:Subsequent research following the BT study has deepened insights into the equity
premium puzzle and organizational myopic loss-aversion (MLA). Studies explored
diverse financial models and behavioral aspects, uncovering nuanced influences on
the equity premium. They examined varied risk factors, investor behaviors, and
market dynamics contributing to the puzzle's persistence. Additionally, investigations
into MLA revealed how institutional pressures, managerial accountabilities, and
competitive market structures might lead to short-term focus despite long-term
investment horizons. These studies widened the understanding of factors impacting
the equity premium and organizational behaviors, offering multifaceted perspectives
to comprehend this complex financial phenomenon.