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Behavioral Finance

Behavioral Finance. Economics 437. Equity Premium Puzzle. Why have stocks earned so much more than bonds? (…than treasury bills?) Not consistent with any reasonable utility function Loss aversion is usual behavioral explanation Originally noted by Rajnish Mehra and Edward Prescott in 1985.

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Behavioral Finance

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  1. Behavioral Finance Economics 437

  2. Equity Premium Puzzle • Why have stocks earned so much more than bonds? (…than treasury bills?) • Not consistent with any reasonable utility function • Loss aversion is usual behavioral explanation • Originally noted by RajnishMehra and Edward Prescott in 1985

  3. Philippe Jorion & William Goetzmann, 1999 • How sure are we that 6 percent premium implies a positive equity premium? • 5 % confidence interval would require 44 years of data • If 3 percent, then 178 years of data to get to the 5 % confidence level • Equity Premium = Rs -RTB • = [CRs + IRs] - [Inflation + Real Rate] • = [CRs - Inflation] + [IRs - Real Rate]. • = approx [CRs – Inflation]

  4. The Data • 39 Markets • 1921 – 1996 • US has 4.3 % real appreciation over the period • Median for all countries is 0.8 % • Globally diversified real return is 4.0 % (3.26 % if everything invested outside of the US is lost)

  5. END

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