The Loss Aversion / Narrow Framing Approach to the Equity Premium Puzzle
37 Pages Posted: 26 Jul 2006 Last revised: 4 Oct 2006
Date Written: July 2006
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.
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