Myopic loss aversion and the equity premium puzzle: An alternative explanation applied to the Danish stock market

Line Isager-Nielsen

Student thesis: Master thesis

Abstract

This thesis presents an attempt to resolve the well-known equity premium puzzle using insight from behavioural finance – namely prospect theory and the concept known as myopic loss aversion. The notion is that the reason why economist have had such a hard time reconciling the predictions of standard expected utility theory to real world observations is that decision makers do not behave as suggested by the standard normative model. Rather a new descriptive theory is warranted since decision makers in their behaviour are observed to violate vital assumptions underlying utility maximisation. The thesis firstly reviews the original equity premium puzzle from 1985, presenting the finding that observed stock returns in the US by far exceed the predictions of expected utility theory. Only an assumption of implausibly high risk aversion of agents is able to reconcile empirics and theory. The thesis then proceeds to argue the failure of expected utility theory as a useful descriptive model of decision making behaviour. As the alternative, prospect theory is presented. A purely descriptive model that encompasses loss aversion, i.e. the notion that a loss to an agent is more hurtful than an equivalent win is pleasurable. Prospect theory is combined with myopia to build the alternative description of decision making behaviour. Myopia is related to mental accounting and captures the assertion that individual are constantly monitoring the success or failure of their financial dispositions. Thus the alternative description of behaviour is myopic loss aversion – agents are aggravated extraordinarily by losses and are frequently evaluating results. Stocks are volatile and will drop in value from time to time but over the long run the average return is high. Myopic loss averse investors will evaluate often and be hurt by volatility – by observing losses – and so they will view stocks as a less attractive investment than if they were rational. In turn they will demand a higher premium to invest in stocks. This is the rationale for why describing investors as myopic loss averse should result in a higher observed risk premium to stock investment. In the empirical part of the thesis, the theoretical argument is put to work on Danish stock market data, where firstly it is confirmed that there exists an equity premium puzzle similar to the one documented in the US twenty years ago. Secondly a model based on prospect theory and myopic loss aversion is fitted to the Danish data to arrive at the implied factors of investor behaviour. The results show that the approach can reconcile the puzzle in Denmark if it is assumed that myopic investors evaluate results every year and are hurt approximately twice as hard by a loss than pleased by a similar gain. These assumption lead to the observed equity premium but also optimal asset allocations very similar to observed behaviour in the Danish market.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2006
Number of pages96