The Equity Premium Puzzle: Defining a Robust Risk Aversion Coefficient

By

Fred Viole
OVVO Financial Systems
fred.viole@gmail.com

And

David Nawrocki
Villanova University
Villanova School of Business
800 Lancaster Avenue
Villanova, PA 19085 USA
610-519-4323
david.nawrocki@villanova.edu
 The Equity Premium Puzzle: Defining a Robust Risk Aversion Coefficient

ABSTRACT

The equity premium puzzle has confounded economists since its presentation in Mehra
and Prescott (1985). Numerous solutions have been offered that challenge the risk aversion
coefficient or α. These solutions have been discredited due to “implausibly large” levels of risk
aversion. However, when examining the Allais paradox, we find these “implausibly large”
levels of risk aversion. These levels of risk aversion are also present in analysis of contestant
behavior from the game show “Deal or No Deal.” By incorporating Ellsberg’s (1961) ambiguity
parameters into an overall risk aversion coefficient, we are able to define a more theoretically
robust α. The puzzle appears not to be the equity premiums witnessed over time; rather the true
puzzle is the rationale of the artificial risk aversion parameter constraints.
“In mathematics you don’t understand things. You just get used to them.”

Johann von Neumann

INTRODUCTION

In 1953, Allais introduced his paradox, used to highlight inconsistencies with expected utility

theory. These inconsistencies have been replicated over the decades in attempts to better define

investor utility, most notably with Ellsberg’s Paradox in 1961 and Kahneman and Tversky’s

Prospect Theory in 1979. When a certain outcome is presented respondents overwhelmingly

select the certain amount versus the alternative choice with a greater expected value while

avoiding structured ambiguity. These noted behavioral biases - ambiguity aversion, the certainty

effect, and loss-aversion have been observed with dissimilar inter asset class returns demanded

by investors. Mehra and Prescott (1985) introduced the Equity Premium Puzzle in order to

describe investor behavior creating the premium of equities to their certain alternative, US

Treasuries.

DEVELOPMENT

The magnitude of ambiguity aversion, loss-aversion and the certainty effect aggregated are

underappreciated when outcomes with certain choices are presented. A closer examination of

Allais’ Paradox will reveal the much larger influence of the certainty equivalent, compared to

conventional loss-aversion assumptions. Per Prospect Theory (Kahneman and Tversky, 1979),

loss aversion (λ) is approximated at 2.25. In Allais (1953), the respondents suggest that the

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event of a zero return compared to the certain alternative is 39 times that amount offered in his

first set of situations offered. The outcome is presented below.

EXPERIMENT 1 (Most participants choose A)

SITUATION A SITUATION B
$1m with certainty 89% chance of $1m; 10% chance of $5m; 1% chance of nothing
U($1 M) > 0.89U($1 M) + 0.01U($0 M) + 0.1U($5 M)

-0.01U($0 M) > 0.1U($5 M) – 0.11U($1 M)

U($0 M) < 0

Allow x to equal the 0 return event

-0.01(x) > 0.1(5) - 0.11(1)

-0.01(x) > 0.5 - 0.11
-0.01(x) > 0.39
x > -39

Allais’ (1953) observations are further supported by Kahneman and Tversky’s (1979) Prospect

Theory examples as well as Markowitz (1959),

“I cannot further interrogate Allais’ subjects, but I have found that my colleagues
and acquaintances give similar responses.” Markowitz (1959)
“The following pair of choice problems is a variation of Allais’ example, which
differs from the original in that it refers to moderate rather than to extremely large
gains…Moreover, the analysis of individual patterns of choice indicates that a
majority of respondents (61 per cent) made the modal choice in both problems.
This pattern of preferences violates expected utility theory in the manner
originally described by Allais.” Kahneman and Tversky (1979)

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Allais’ (1953) subjects exhibit a loss-aversion at most 39 times the certain payoff. A 55 times

multiple is not off by an order of magnitude and is very plausible if the maximum amount in

Allais’ examples were simply increased to $6.6 million from $5 million. What is the relevance

of a 55 times multiple? From Mehra (2006),

“The late Fischer Black (1981) proposed that α = 55 would solve the puzzle.
Indeed it can be shown that the 1889–1978 US experience reported above can be
reconciled with α = 48 and β = 0.55.

To see this, observe that since

𝑣𝑎𝑟(𝑥)
𝜎𝑥2 = ln [1 + ] = 0.00123 (1)
[𝐸(𝑥)]2
and
1
𝜇𝑥 = 𝑙𝑛𝐸(𝑥) − 𝜎2 = 0.0175 (2)
2 𝑥

this implies
ln 𝐸(𝑅)−ln 𝑅𝐹
𝛼= = 48.4 (3)
𝜎𝑥2

Since
1
ln 𝛽 = − ln 𝑅𝐹 + 𝛼𝜇𝑥 − 2 𝛼 2 𝜎𝑥2 = −0.60 (4)

this implies
𝛽 = 0.55 (5)

Besides postulating an unacceptably high α, another problem is that this is a

‘knife edge’ solution. No other set of parameters will work, and a small change in
α will lead to an unacceptable risk-free rate as shown in Figure 3.3. An alternate
approach is to experiment with negative time preferences; however there seems to
be no empirical evidence that agents do have such preferences.”1

1
Equations reproduced exactly as presented in Mehra (2006), p.21.

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Figure 1. Figure 3.3 reproduced from Mehra (2006).

Mehra (2006) goes on to further disprove solutions with interpreted high levels of α,

“Most studies indicate a value for α that is close to 3.”

“Furthermore, for the reported simulation, the agent’s effective CRRA varies
between one and one hundred, which is arguably extreme.”

“To summarize, models with habit formation and relative or subsistence

consumption have had success in addressing the risk-free rate puzzle but only
limited success with resolving the equity premium puzzle, since in these models
effective risk aversion and prudence become implausibly large.”

“The analysis above shows that the isoelastic preferences used in Mehra and
Prescott (1985) can only be made consistent with the observed equity premium if

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 the coefficient of relative risk aversion is implausibly large. One restriction
imposed by this class of preferences is that the coefficient of risk aversion is
rigidly linked to the elasticity of intertemporal substitution. One is the reciprocal
of the other. What this implies is that if an individual is averse to variation of
consumption across different states at a particular point of time then he will be
averse to consumption variation over time. There is no a priori reason that this
must be so. Since, on average, consumption is growing over time, the agents in
the Mehra and Prescott (1985) setup have little incentive to save. The demand for
bonds is low and as a consequence, the risk-free rate is counterfactually high.”

Is it possible that the reason numerous solutions exist with implausibly large risk aversion

coefficients is that this coefficient is not being defined correctly?

Viole and Nawrocki (2011) provide an expanded analysis of the Deal or No Deal Data presented

by Post et al. (2008) adding a tangible analysis to the study of decisions under uncertainty. The

game show involves contestants selecting a briefcase with a sealed amount then opening

briefcases containing amounts that are then removed from the possible outcomes. After each

round, the “bank” offers the contestant an amount for their sealed briefcase. For example, a

contestant maybe offered $400,000 from the bank when there are two briefcases remaining with

remaining values $1 and $1 million. Table 1 illustrates the Deal or No Deal data supporting

Allais’ certainty equivalence observations.

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Table 1. Deal or No Deal Income to Deal ratios

Percentage of Bank Offer

Country Mean Deal Amount Multiple of per capita income2
Accepted

Germany €20,602.56 0.69 91.8

U.S. $122,544.58 2.53 91.4

Netherlands €227,264.90 6.49 76.3

Perhaps it is solely due to the larger prize pool in the Dutch version, or perhaps it is due

to the frequency of participation in this one chance, whereby the contestant does not wish to

come away empty handed, thus increasing the certainty equivalent. Samuelson (1963) notes

similar behavioral patterns dictated by frequency via a lunchtime coin toss wager. Of course the

missing data points in the contestant profiles of income and wealth would go a long way in

expanding this, and we would hope should warrant further research into this noticed correlation

of a larger single payoff versus a larger discount to expected value, compared to an increased

frequency of similar situations. Unfortunately, game show producers realize this too and

generally one is only allowed a single visit thereby limiting our data. Benzarti and Thaler (1995)

continue the discussion.

“They found that people would have to have a coefficient of relative risk aversion
over 30 to explain the historical pattern of returns....Also, Mankiw and Zeldes
(1991) provide the following useful calculation. Suppose that an individual is
offered a gamble with a 50 percent chance of consumption of $100,000 and a 50
percent chance of consumption of $50,000. A person with a coefficient of relative
risk aversion of 30 would be indifferent between this gamble and a certain
consumption of $51,209. Few people can be this afraid of risk”3

2 IMF 2008 nominal per capita income and an exchange rate of $1.5 to €1 is used to generate the multiple
3 Benzarti and Thaler (1995).

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This discount to expected value within a solely positive utility (no losses involved) of 68.28%

($51,209 certain consumption divided by the expected value $75,000) Mankiw and Zeldes

(1991) identify is in the realm of the 76.3% bank offer accepted in the Dutch version of Deal or

No Deal, and clearly not off by an order of magnitude. Viewed differently, the 4.8% certain

consumption level Mankiw and Zeldes (1991) identify ($1,209 premium to $50,000 (the certain

minimum) divided by the expected value premium $25,000 ($75,000 expected value of the

gamble less the certain minimum of $50,000)) is also consistent with the percentages provided

by Post et al. (2008); where their path dependent model implied certainty coefficient for the

neutral group of Dutch contestants implies indifference at 3.2% of expected value for large

prizes.4 Are the Dutch that afraid of risk or is risk not being defined correctly? The Dutch also

went through a path dependent dynamic decision process to arrive at their discount versus a

fictional one shot deal. The coefficient of relative risk aversion over 30 that Mankiw and Zeldes

(1991) tried to highlight blatantly ignores the certainty equivalent individuals clearly exhibit by

defining this coefficient as solely loss aversion.5 Also, assume a more realistic scenario observed

with equity investments whereby portfolios often represent multiple times an individual's annual

income, there were a downside risk represented such that the bet is equally likely to lose

$150,000 or pay $300,000 yielding the same expected value of $75,000. Does the propensity to

accept a certain payoff of $51,209 representing a conventional loss-aversion coefficient ex

certainty equivalence seem that peculiar? The following argument will isolate the loss-aversion

coefficient from the effect of the certainty equivalence.

4 Post et al. (2008) p. 47.

5 Sections 4 and 5 of Viole and Nawrocki (2011) identify the concave loss-aversion with gains, since there are no losses or LPM in the game
show or Mankiw and Zeldes (1991) example.

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Equation 3.21 from Mehra (2006) shows that

ln 𝐸{𝑅𝑒 } − ln 𝑅𝑓 = α𝜎𝑥2 (6)

where the equity premium [ln 𝐸{𝑅𝑒 } − ln 𝑅𝑓 ] is the product of the coefficient of relative risk

aversion α, and 𝜎𝑥2 the variance of the continuously compounded growth rate of consumption.

𝜎𝑥2 is further defined by Mehra (2006) as

𝑣𝑎𝑟(𝑥)
𝜎𝑥2 = ln [1 + ] (7)
[𝐸(𝑥)]2

“As we see below, this variance is 0.001369, so unless the coefficient of risk
aversion α is large, a high equity premium is impossible. The growth rate of
consumption just does not vary enough!” Mehra (2006)

This allows us to assume a de minimus constant 𝜎𝑥2 when comparing the Allais Paradox to its

reproduction in prospect theory problem 1, and the gamble provided by Mankiw and Zeldes

(1991). Under this assumption, the Mankiw and Zeldes gamble only infers a 18.75% increase in

α, compared to the Allais as illustrated in Table 2 below.

Table 2. Ranges of equity premium as defined by (𝐥𝐧 𝑬{𝑹𝒆 } − 𝐥𝐧 𝑹𝒇 ).

Prospect Theory

Problem 1 Allais Paradox Mankiw and Zeldes

α𝜎𝑥2 = 𝑙𝑛(2,409) − 𝑙𝑛(2,400) 𝑙𝑛(1,390,000) − 𝑙𝑛(1,000,000) 𝑙𝑛(75,000) − 𝑙𝑛(51,209)

α𝜎𝑥2 =
7.79 – 7.78 14.14 – 13.82 11.23 – 10.84

α𝜎𝑥2 =
0.01 0.32 0.38

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In equation 3.2 Mehra (2006) identifies α under an increasing, continuously differentiable

concave utility function further restricted to be of the constant relative risk aversion (CRRA)

class,

𝑐 1−α
𝑈(𝑐, α) = , 0 < α < ∞, (8)
1−α

where the parameter α measures the curvature of the utility function. Aside from dismissing the

strong evidence for non-concave reverse-S utility functions (Levy and Levy [2002], Viole and

Nawrocki [2011]), Ellsberg (1961) identifies ambiguity as an autonomous variable,

“Ambiguity is a subjective variable, but it should be possible to identify

“objectively” some situations likely to present high ambiguity, by noting
situations where available information is scanty or obviously unreliable or highly
conflicting; or where expressed expectations of different individuals differ wildly;
or where expressed confidence in estimates tends to be low.”

Ellsberg (1961) then offers a decision rule compensating ambiguity,

[𝜌 . 𝑦 0 + (1 − 𝜌)𝑦𝑥𝑚𝑖𝑛 ](𝑥) (9)

where 𝜌 is the degree of confidence, 𝑦 0 is the estimated probability vector, 𝑦𝑥𝑚𝑖𝑛 the probability

vector in 𝑌 0 corresponding to minx for action x and (X) is the vector of payoffs for action x. (𝑌 0 ,

𝑦 0 , X and 𝜌 are all subjective data to be inferred by an observer or supplied by the individual,

depending on whether the criterion is being used descriptively or for convenient decision-

making).

Using Ellsberg’s definition of a situation of high ambiguity,

“Let us imagine a situation in which so many of the probability judgments an

individual can bring to bear upon a particular problem are either “vague” or

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 “unsure” that his confidence in a particular assignment of probabilities, as
opposed to some other of a set of “reasonable” distributions, is very low. We may
define this as a situation of high ambiguity.”

and factoring the subjective nature of ambiguity we can redefine α as

(1+𝜎2 0 )
𝜆 𝑦
𝛼= (10)
𝜌

where λ is the loss-aversion parameter, 𝜌 is the degree of confidence, and 𝜎𝑦20 is the variance of

the estimated probability vector. Then Mehra’s equation is transformed into our equation 11,

(1+𝜎2 0 )
𝜆 𝑦
𝑙𝑛𝐸{𝑅𝑒 } − 𝑙𝑛𝑅𝑓 = ( ) 𝜎𝑥2 (11)
𝜌

allowing for a small variance of loss-aversion and affording a large range for ambiguity aversion,

commensurate with the gamble presented – explaining the “implausibly large” α. In the instance

𝜎𝑦20 = 0 such as a fair gamble then, the individual would be indifferent as to its outcome leaving

loss-aversion and confidence in the situation presented to dictate their payment for an expected

value. Individuals are generally reluctant to participate in a fair symmetric gamble with no

discount to expected value. This is consistent with Markowitz (1952),

“We do not observe persons of middle income taking large symmetric bets. We
expect people to be repelled by such bets. If such a bet were made, it would
certainly be considered unusual and probably irrational.”

A large α infers individuals dislike ambiguity an order of magnitude greater than losing, creating

an influence fully consistent with Ellsberg (1961).

“It would seem incautious to rule peremptorily that the people in question should
not allow their perception of ambiguity, their unease with their best estimates of
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 probability, to influence their decision: or to assert that the manner in which they
respond to it is against their long-run interest and that they would be in some
sense better off if they should go against their deep felt preferences.”

THE RISK-FREE RATE PUZZLE

Ambiguity aversion as a means of addressing the equity premium puzzle has often failed to

simultaneously address the risk free rate puzzle.

“’The Equity Premium Puzzle (EPP) states that equity returns are too high relative
to bond returns that can be explained by reasonable levels of risk aversion and
discount rates. If risk aversion were high as implied by the difference between
equity and bond returns, bond returns would have to be much higher than they
actually are. The latter part of the problem is known as the risk-free rate puzzle.’
Hence, models attempting to explain the EPP with agents, who are, effectively,
very risk averse, can only explain the difference in returns between bonds and
equity, but fail to explain the ensuing risk-free rate puzzle.” (Eisenbach and
Schmalz, [2011]).

Risk-free government bonds offer a certainty of repayment of principle and interest, hence the

term “risk free.” Thus the degree of certainty associated with the risk-free securities (𝜌) will be

higher than the (𝜌) assigned to a corporate equity investment. Moreover, the variance of the

probability vector (𝜎𝑦20 ) equals 0 if the risk-free bond is held to maturity. Individually, these

differences would lower the overall α, and factored simultaneously will drastically reduce the

overall risk aversion coefficient α for a risk-free government bond compared to an equity

investment.

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Figure 2 below illustrates our argument.

Equity Premium Puzzle

Fisher Black’s Solution Mankiw and Zeldes (1991)

α = 55 Indifference Between $51,209 and

Expected Value of $75,000
Supports

Allais’ Paradox (1953) Dutch Contestants Post et al. (2008) Certainty

Accept Deal of 76.8% Coefficient of 3.2% of
Zero Return 39 times Certain Payoff of Expected Value Expected Value

Figure 2. Diagram of examples offering solutions to the Equity Premium Puzzle and their

supporting evidence.

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CONCLUSIONS

We have illustrated with Allais’ (1953) Paradox; with tangible analysis of contestant behaviors

in Deal or No Deal half a century later; that ambiguity aversion in context of a certain outcome

scenario is greatly misrepresented with conventional loss-aversion parameters. This consistent

pattern of individual behavior is responsible for the premiums investors demand in equities

versus their certain alternative, US Treasuries.

There is no equity premium “puzzle” when Ellsberg’s (1961) ambiguity aversion parameters 𝜌

and the variance of the estimated probability vector are included in the overall risk aversion

coefficient (α) as provided in equation 1. Investors demand highly asymmetrical payouts in the

presence of Knightian uncertainty for compensation of ambiguity, especially in equity prices. If

such asymmetry is not offered, the certain alternative will prevail per Allais (1953), Ellsberg

(1961) and Kahneman and Tversky (1979). This certainty equivalence exudes a power and

pervasiveness completely underappreciated with historical risk aversion analysis. Ambiguity

aversion is a simple phenomenon to document as Ellsberg (1961) noted and it is a consistent

human behavior; with variants as observed by The Economist (1999) some 40 years later.

"Perhaps the best-known example of prospect theory in action is in suggesting a

solution to the “equity-premium puzzle”. In America, shares have long delivered
much higher returns to investors relative to bonds than seems justified by the
difference in riskiness of shares and bonds. Orthodox economists have ascribed
this simply to the fact that people have less appetite for risk than expected. But
prospect theory suggests that if investors, rather like racegoers, are averse to
losses during any given year, this might justify such a high equity premium.
Annual losses on shares are much more frequent than annual losses on bonds, so
investors demand a much higher premium for holding shares to compensate them
for the greater risk of suffering a loss in any given year."6

6
http://www.economist.com/node/268946

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Less appetite for risk than expected per expected utility theory; or compensation for the greater

risk frequency per prospect theory both argue the solution lies in the risk aversion coefficient.

The “unusual and probably irrational” bet Markowitz (1952) referenced is supported by the fact

that the degree of confidence (𝜌) in the situation would have to equal 1 and the loss-aversion (𝜆)

would have to equal 1, approximating a linear utility function - indifference.

(1+𝜎2 0 )
𝜆 𝑦
𝛼 ≠ 𝜆 per Mehra’s assertion, rather 𝛼 = thus, a more robust definition of the relative
𝜌

risk aversion coefficient can easily explain the “implausibly large” risk aversion coefficient

solutions to the Equity Premium Puzzle that have been demonstrated while simultaneously

explaining the Risk-Free Rate Puzzle.

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REFERENCES

Allais, P.M. (1953). “Le Comportement de L’Homme Rationnel Devant Le Risque: Critique des
Postulats et Axiomes de L’Ecole Americaine,” Econometrica, v21(4), 503-546.
Benzarti, S. and R.H. Thaler (1995). “Myopic Loss Aversion and the Equity Premium Puzzle.”
Quarterly Journal of Economics, 110(1), 73-92.
Black, F. (1981) Private communication with R.Mehra (2006).
Eisenbach, T. M. and Schmalz, M. C. “Anxiety in the Face of Risk” (November 1, 2011).
Economic Theory Center Working Paper No. 29-2011. Available at SSRN:
http://ssrn.com/abstract=1973229
Ellsberg, D. (1961). “Risk, Ambiguity, and the Savage Axioms.” Quarterly Journal of
Economics, 75 (4), 643-669.
Kahneman, D., and A. Tversky. (1979). "Prospect Theory: An Analysis of Decision Making
under Risk." Econometrica, 47, 263-291.
Mankiw, N. Gregory, and Zeldes, S.P. (1991). “The Consumption of Stockholders and
Nonstockholders.” Journal of Financial Economics, 29, 97-112.

Markowitz, H. (1952). “The Utility of Wealth.” Journal of Political Economy, 60, 151-158.

Markowitz, H. (1959). Portfolio Selection: Efficient Diversification of Investments.

Mehra, R. (2006). "The Equity Premium Puzzle: A Review", Foundations and Trends in
Finance, Vol. 2, No. 1, 1-81.

Mehra, R., and E.C. Prescott. (1985). “The Equity Premium: A Puzzle.” Journal of Monetary
Economics, vol. 15, no. 2, (March):145–161.

Post, T., Van den Assem, M., Baltussen, G., and Thaler, R. (2008). “Deal or No Deal? Decision
Making under Risk in a Large-Payoff Game Show.” American Economic Review, March 2008,
(98:1), 38-71.
Samuelson, Paul A. (1963). “Risk and Uncertainty: A Fallacy of Large Numbers.” Scientia,
XCVIII, 108-13.

The Economist, (1999). “Irrationality: Rethinking Thinking,” December 16, 1999.

Viole, Fred, and Nawrocki David, (2011). “The Utility of Wealth in an Upper and Lower Partial
Moment Fabric.” Journal of Investing, Summer 2011, Vol. 20, No. 2, 58-85.

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