Disappointment, Pessimism and the Equity Risk Premia

Abstract

We analyze the implications of the introduction of disappointment averse agents on the financial markets. The underlying intuition is that agents take account for the potential disappointment of their decisions, in particular when they invest on the stock market. After having defined the concepts of disappointment aversion, we show that in our framework a disappointment averse agent is pessimistic. We then explore the consequences of disappointment aversion and pessimism on the CAPM and the C-CAPM. We finally study a Lucas asset pricing model that is standard, except that the representative agent is supposed to be disappointment averse. Using a constant marginal utility function, we show that the model can account for both large equity risk premia and low risk-free rates. It may so be viewed as a solution to the equity premium puzzle

Keywords: Behavorial Finance, Disappointment, Equity Premium

JEL Classification: D81, G12