1. Myopic loss aversion is a concept that Benartzi and Thaler used to explain the equity premium puzzle.
They explain that myopic loss aversion is a combination of high sensitivity to losses and tendency to
frequently evaluate one’s wealth. Hence, in order to understand myopic loss aversion, we should
know about both of the factors mentioned.
First of all, high sensitivity to losses can be simply called loss aversion, which is first introduced by
Daniel Kahneman and Amos Tversky in 1979. What it means is that people tend to be more sensitive
to decreases in their wealth than to increases. According to some empirical results, losing something
is weighed twice as great as getting it. Thus, basically this theory proves that expected utility theory,
which states that people under uncertain situation make decision by comparing expected utility values,
cannot be valid under uncertainty.
The second factor, behavior of monitoring their wealth frequently, needs an introduction of another
concept, mental accounting, which is named by Thaler in 1980. Mental accounting is implicit
operations individuals use to measure their financial activities. Among several components of mental
accounting, what we concern is frequency of the accounting valuation. Whenever they do the
accounting, they consider gains and losses relative to their own reference point rather than the total
wealth level. This behavior, again, is contrast to expected utility theory. As a result, an individual with
loss-aversion preference is less willing to accept risk.
These two factors make investors being reluctant to hold equities because it has higher return
variability, in other words risk. Benartzi and Thaler argues that this is why there is large premium on
equity compared to bond.