Discussion and Critical Review of the Equity Premium Puzzle

Topics: Stock market, Risk aversion, Stock Pages: 9 (2958 words) Published: March 19, 2013
Discussion and critical review of the Equity Premium Puzzle

First time this phenomenon was presented by the economists Rajnish Mehra and Edward Prescott in 1985. They discovered that the return from US equity investments in comparison to the return from a risk free government securities had been much far above during the twentieth century to be interpreted by the traditional economic theories (Siegel and Thaler, 1997). Also, significant research on equity premium puzzle was made by the Siegel. Siegel examined returns on US stocks and fixed income securities starting from year 1802 till 1990. By dividing entire period into three phases 1802 - 1870, 1871 – 1925, 1925 – 1990, he discovered that income from investing in stocks was surprisingly stable, while return on government securities declined considerably during the same time frame. Over three time horizons, real compound returns on stocks were 5.7, 6.6 and 6.4 percent respectively, at the same time as earnings from fixed income securities amounted only 5.1, 3.1 and 0.5 percent (Benartzi and Thaler, 1995). Reviewing data discovered by Siegel, it is becoming obvious that during the last two subperiods income from trading stocks significantly exceeded bonds’, difference reaching almost 6 percent in the final phase. There were many attempts and researches made to explain the existence of this phenomenon. For several past decades scholars made attempts to explain equity premium puzzle, providing both theoretical and empirical explanations in their researchers. Probable explanations covered imperfections of the markets, empirical concepts such as mean reversion and mean aversion, investors’ behaviours as habit formation and loss aversion and others. First part of this paper will explore theoretical basis of equity premium puzzle, emphasizing attention on heavily discussed myopic loss aversion model. While one believes in the existence of the equity premium puzzle and tries to solve this problem, another part of scholars rejects essence of this phenomenon. Proponents of the equity premium puzzle refer to the selection and survivorship biases as being admitted while researching the equity premium phenomenon. This opinion is certainly relevant, considering the recent changes in the financial markets performance. During the past decade stock market outlived severe recession and crash of financial markets, that significantly decreased the average returns on equities and increased volatility. The second part of the paper will discuss both of these notions (selection and survivorship bias) and analyze recent financial data on stock returns observed in last 30 years. Myopic loss aversion

Among the existing interpretations of the equity premium puzzle, behavioural finance attempts to explain much of the risk premium on the stock market. One of such approaches is myopic loss aversion model. This behavioural finance approach was first described by Kahneman and Tversky (1979). With the assumption that the utility function of investors is retrieved from variations in the profitability of their portfolios, they conclude that investors are afraid of losses, in other words they are loss averse. According to the Tversky and Kahneman, investors are much more concerned with potential losses rather than they are pleased with the same amount of returns. Share prices in the daily time-frame drop as often as they rise. If investors value their assets every day, they have to feel disappointment from frequent falls in stock prices. Loss aversion in this case only increases their frustration as losses are psychologically doubled. Accordingly, investors seek higher earnings from stocks as a reward for risk (Siegel and Thaler, 1997). Through simulating monthly yields on stocks and fixed income securities from 1926 till 1990, Benartzi and Thaler identified combination of loss aversion and estimation period needed to explain the enormous historical returns of U.S. stocks. Research...
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