Question

An individual faces the following to investment options:
Investment A: buy a stock fund that every year either earns 50% with a probability of 60% or loses -25% with a probability of 40%.
Investment B: buy a bond that returns 5% with a probability of 50% or 0% with a probability of 50%.
Assume that the returns of the two funds are independent and that returns from year to year are also independent. Also, assume an initial investment of £1.
The value function of the individual is specified as:
V(z)=z for z>0
V(z)= 3.5z for z<0
4.1) Which investment option would the investor choose if he looks at the investment once per year?

4.2) Which investment option would the investor choose if he looks at the investment once every two years?

4.3) Discuss the term “Myopic loss aversion”

4.4) Explain the equity premium puzzle. Why is it deemed to be a puzzle?

4.5) How can myopic loss aversion explain the equity premium puzzle?

Answer 1

Return on A = 50%*60% + (-25%*40%) = 2%

4.3 Myopic loss aversion was suggested by Benartzi and Thaler (1995) as an explanation for the equity premium puzzle. Its main prediction is that loss averse investors, who evaluate their investment performance too frequently and therefore often observe small losses on their stock portfolios, would invest too little in equity.

4.4 The equity premium puzzle (EPP) is a phenomenon that describes the anomalously higher historical real returns of stocks over government bonds. The equity premium, which is defined as equity returns minus bond returns, has been approximately 6.4% on average over a 100+ year period in the U.S.

The premium is supposed to reflect the relative risk of stocks compared to "risk-free" government bonds, but the puzzle arises because this unexpectedly large percentage implies an unreasonably high level of risk aversion among investors.

4.5  Myopic loss aversion was suggested by Benartzi and Thaler (1995) as an explanation for the equity premium puzzle. Its main prediction is that loss averse investors, who evaluate their investment performance too frequently and therefore often observe small losses on their stock portfolios, would invest too little in equity. We investigate the link between myopic loss aversion and actual investment decisions of individual investors, using survey data. The results are consistent with the predictions of Benartzi and Thaler. Higher myopic loss aversion is associated with lower stock investment as a share of total assets. Investors tend to evaluate their stock portfolio performance too often, which contributes to the prevalence of myopic loss aversion. The effect of myopia is most apparent when investors both evaluate their portfolios frequently and trade stocks regularly.