Myopic Loss Aversion and the Equity Premium Puzzle

The equity premium puzzle, first documented by Mehra and Prescott, refers to the empirical fact that stocks have greatly outperformed bonds over the last century. As Mehra and Prescott point out, it appears difficult to explain the magnitude of the equity premium within the usual economics paradigm because the level of risk aversion necessary to justify such a large premium is implausibly large. We offer a new explanation based on Kahneman and Tversky's 'prospect theory'. The explanation has two components. First, investors are assumed to be 'loss averse' meaning they are distinctly more sensitive to losses than to gains. Second, investors are assumed to evaluate their portfolios frequently, even if they have long-term investment goals such as saving for retirement or managing a pension plan. We dub this combination 'myopic loss aversion'. Using simulations we find that the size of the equity premium is consistent with the previously estimated parameters of prospect theory if investors evaluate their portfolios annually. That is, investors appear to choose portfolios as if they were operating with a time horizon of about one year. The same approach is then used to study the size effect. Preliminary results suggest that myopic loss aversion may also have some explanatory power for this anomaly.

Save More Later? The Effect of the Option to Choose Delayed Savings Rate Increases on Retirement Wealth

Prior research in economics and psychology has documented that individuals exhibit time-inconsistent preferences when faced with the opportunity to take an action that involves immediate costs in return for future benefits – the notion of implementing such an action now is unappealing, but the notion of implementing the same action later is attractive. Because increasing contributions to a retirement savings plan requires a reduction in current consumption (an immediate cost) in order to increase consumption in old age (a future benefit), individuals may be more likely to agree to a contribution rate increase if they have the option to have the increase implemented at a delay. We conducted a field experiment with several universities to test whether the option to choose a delayed contribution rate increase boosts savings. Relative to employees who are offered a convenient mechanism for increasing their contribution rates immediately, employees who are offered a convenient mechanism for increasing their contribution rates immediately or at a delay are no more likely to agree to an increase. In fact, the latter group exhibits lower savings rates over the coming months, as the delayed option attracts some employees. However, when the delayed option is framed as being implemented after a psychologically meaningful moment, such as an employee’s next birthday, the negative effect of offering a delayed option is undone

Tax evasion and exchange equity: a reference-dependent approach

The standard portfolio model of tax evasion with a public good produces the perverse conclusion that when taxpayers perceive the public good to be under-/overprovided, an increase in the tax rate increases/decreases evasion. The author treats taxpayers as thinking in terms of gains and losses relative to an endogenous reference level, which reflects perceived exchange equity between the value of taxes paid and the value of public goods supplied. With these alternative behavioral assumptions, the author overturns the aforementioned result in a direction consistent with the empirical evidence. The author also finds a role for relative income in determining individual responses to a change in the marginal rate of tax

Measuring Risk Attitudes Controlling for Personality Traits*

Abstract: This study measures risk attitudes using two paid experiments: the Holt and Laury (2002) procedure and a variation of the game show Deal or No Deal. The participants also completed a series of personality questionnaires developed in the psychology literature including the risk domains of Weber, Blais, and Betz (2002). As in previous studies risk attitudes vary within subjects across elicitation methods. However, this variation can be explained by individual personality traits. Specifically, subjects behave as though the Holt and Laury task is an investment decision while the Deal or No Deal task is a gambling decision

The Availability Heuristic, Intuitive Cost-Benefit Analysis, and Climate Change

Because risks are on all sides of social situations, it is not possible to be “precautionary” in general. The availability heuristic ensures that some risks stand out as particularly salient, whatever their actual magnitude. Taken together with intuitive cost-benefit balancing, the availability heuristic helps to explain differences across groups, cultures, and even nations in the assessment of precautions to reduce the risks associated with climate change. There are complex links among availability, social processes for the spreading of information, and predispositions. If the United States is to take a stronger stand against climate change, it is likely to be a result of available incidents that seem to show that climate change produces serious and tangible harm

A Multi-Objective Decision Framework for Lifecycle Investment

In this paper we propose a multi-objective decision framework for lifecycle investment choice. Instead of optimizing individual strategies with respect to a single-valued objective, we suggest evaluation of classes of strategies in terms of the quality of the tradeoffs that they provide. The proposed framework takes inspiration from psychological theories which, on the one hand, assert that humans analyze risky choice situations in terms of several competing factors, and, on the other hand, recognize that attribute overload is detrimental to decision making. In particular, we use SP/A (security-potential/aspiration) theory as developed by Lopes and co-authors. The proposed approach is illustrated in a simple lifecycle model. As decision factors, we consider (a) the contribution paid, (b) the ambition level (targeted level of retirement income), and (c) the guarantee level (a level of retirement income that will be achieved with high probability). In terms of the tradeoffs generated between these indices, we compare a class of traditional lifecycle strategies, defined in terms of a glide path, with a class of so called collar strategies