Tuesday, August 13, 2019

The Phenomenon of the Equity Premium Puzzle Assignment

The Phenomenon of the Equity Premium Puzzle - Assignment Example Myopic loss aversion is a behavioral finance approach used to explain the size of equity risk premium. Behavioral finance deviates from the standard economic theory and integrates the human psychology with economic theory. The concept of myopic loss aversion rests on two principals   It includes the cognitive and unconscious operations used by people to organize, evaluate and keep track of financial activities. This approach implies that people tend to make and evaluate decisions one at a time and then they place them in separate mental accounts rather than evaluate them in a broader context. In a financial perspective, this refers to how transactions are grouped both cross-sectionally (are securities evaluated one at a time or as portfolios) and inter-temporally (how often are portfolios evaluated). When this narrow evaluation of the decisions and outcomes take place, financial investors will tend to make short-term decisions rather than adopt long-term policies regarding their investments and evaluate their gains and losses frequently. â€Å"When we look at the historical record of investment returns, we find that the vast majority of long-term returns are derived from just seven percent of all trading months. The returns of the remaining ninety-three percent of the months on average are virtually zero†. It implies that the shorter the investment horizon, greater the chances that the investor will experience a loss in the value his portfolio. Moreover, if an investor has the risk-averse preferences then the time horizon over which he evaluates his portfolio also impacts his investment preferences. For example, stocks seem to be risky and yield fewer returns in the short run, while debt instrument is safer and seem to be profitable in short run. So if a risk inverse investor inspects his portfolio daily then he will find the bonds much more profitable and attractive as compared to stocks and will find the stock highly risky and yielding lower returns, because stock prices highly fluctuate up and down on daily basis and losses have a double effect on investor’s mind.

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