Myopic Loss Aversion and the Equity Premium Puzzle - The Impact of Probability Weighting on Prospective Utility

Abstract

Benartzi and Thaler (1995) show that the equity premium puzzle can be explained by a combination of loss aversion and mental accounting dubbed myopic loss aversion. In replicating some of the results of Benartzi and Thaler (1995) we find that overweighting of low and underweighting of moderate and high probabilities has a profound effect on the utility derived from stock returns over different evaluation periods. Specifically, it causes utility of stock returns to fluctuate over consecutive evaluation periods. The results of this is a lengthier evaluation period for which utility derived from stock returns and T-bills returns is equal, suggesting a lower equity premium.

Keywords: myopic loss aversion, cumulative prospect theory, behavioral finance

JEL Classification: G10, G12