Investments, tenth edition

  Behavioral Explanations of the Equity Premium Puzzle 

 Barberis and Huang explain the puzzle as an outcome of irrational investor behavior.  

44

   

The key elements of their approach are loss aversion and narrow framing, two well-known 

features of decision making under risk in experimental settings. Narrow framing is the idea 

that investors evaluate every risk they face in isolation. Thus, investors will ignore low 

correlation of the risk of a stock portfolio with other components of wealth, and therefore 

require a higher risk premium than rational models would predict. Combined with loss 

aversion, investor behavior will generate large risk premiums despite the fact that 

traditionally measured risk aversion is low. (See Chapter 12 for more discussion of such 

behavioral biases.)

  

 Models that incorporate these effects can generate a large equilibrium equity risk pre-

mium 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 plausible predictions about attitudes to independent monetary 

gambles. The analysis for the equity premium also has implications for a closely related 

portfolio puzzle, the stock market participation puzzle. They suggest some possible direc-

tions for future research. 

 The approach of Barberis and Huang, when accounting for heterogeneity of prefer-

ences, can explain why a segment of the population that one would expect to participate 

in the stock market still avoids it. Narrow framing also explains the disconnect between 

consumption growth and market rates of return. The assessment of stock market return in 

isolation ignores the limited impact on consumption via smoothing and other hedges. Loss 

aversion that exaggerates disutility of losses relative to a reference point magnifies this 

effect. The development of empirical literature on the tenets of these theories may deter-

mine the validity and implications of the equity premium puzzle.     

  

44

 Nicholas Barberis and Ming Huang, “The Loss Aversion/Narrow Framing Approach to the Equity Premium 

Puzzle,” in  Handbooks in Finance: Handbook of the Equity Risk Premium  ed. Rajnish Mehra (Amsterdam: 

Elsevier, 2008), pp. 199–229. 

bod61671_ch13_414-444.indd   441

bod61671_ch13_414-444.indd   441

7/17/13   3:47 PM

7/17/13   3:47 PM

Final PDF to printer

---

Visit us at www

.mhhe.com/bkm

442 

P A R T   I I I

  Equilibrium in Capital Markets