Working Paper: NBER ID: w12378
Authors: Nicholas Barberis; Ming Huang
Abstract: We review a recent approach to understanding the equity premium puzzle. The key elements of this approach are loss aversion and narrow framing, two well-known features of decision-making under risk in experimental settings. In equilibrium, models that incorporate these ideas can generate a large equity premium and a low and stable risk-free rate, even when consumption growth is smooth and only weakly correlated with the stock market. Moreover, they can do so for parameter values that correspond to sensible attitudes to independent monetary gambles. We conclude by suggesting some possible directions for future research.
Keywords: Equity Premium; Loss Aversion; Narrow Framing
JEL Codes: G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Loss aversion and narrow framing (G41) | higher equity premium (G19) |
| Investors' heightened sensitivity to losses (G41) | discomfort from stock market fluctuations (G17) |
| discomfort from stock market fluctuations (G17) | demand for a higher equity premium (G19) |
| Narrow framing (F12) | higher equity premium (G19) |
| Narrow framing (F12) | focus on short-term outcomes (C41) |
| focus on short-term outcomes (C41) | demand for a higher equity premium (G19) |
| Loss aversion and narrow framing (G41) | deter individuals from investing in stocks (G10) |
| Focus on potential losses (G41) | deter individuals from investing in stocks (G10) |