This document discusses myopic loss aversion as a potential solution to the equity premium puzzle. It poses key questions around why the equity premium is so large and why anyone holds bonds. The theory is that the combination of loss aversion, as described in prospect theory, and mental accounting, as proposed by Richard Thaler, results in myopic loss aversion which can explain the size of the equity premium if investors frequently evaluate their portfolios, such as every 12 months.

1. Myopic loss aversion as an solution
to the equity premium puzzle
Central questions
•Why is the equity premium so large?
• Why is anyone willing to hold bonds?
Sub-questions – (will be revised, this is just a list of the important ones)
• What combination of loss aversion and evalution period would benecessary to explain the historical pattern of
returns?
• How often would an investor have to evaluate his portfolio in order to be indifferent between the historical
distribution of returns on stocks and bonds?
• Is the equity premium real?
•If investors have prospect theory preferences, how often would they have to evaluate their portfolios to explain
the equity premium?
• Which evaluation period would make investors indifferent between holding all their assets in stocks or bonds?
•For an investor with this evaluation period, what combination of stocks and bonds would maximise prospective
utility?

2. Theory behind the equity premium puzzle
• Prospect theory (Kahneman & Tverksy, 1979)
– Loss aversion
– Mental accounting

3. Loss aversion
Reference point

4. Mental accounting
• Richard Thaler (1980)

5. • Loss aversion + mental accounting
= myopic loss aversion
The combination of a very high sensitivity to losses
combined with the tendency to evaluate portfolios
frequently (every 12 months) provides an
explanation to the size of the premium, and hence
a solution to the puzzle.