INSTITUTE –University School of Business

DEPARTMENT -Management
Program Name
Course Name: Behavioral Finance and Analytics
Course Code: 22BAA 754
Chandigarh University, Mohali

Foundations of Finance

UNIT-1 – Chapter
Name DISCOVER . LEARN . EMPOWER

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 Learning Objectives Foundations of Finance

CO Title Level
Number Foundations of Finance –
CO1 To gain an understanding of the concepts Remember Standard and Behavioural
of behavioral finance.
CO2 Analyze psychographic models used in Understand
behavioral finance by retail investors for
investment decisions
CO3 To analyze the effect of different Understand
Behavioural influences on various
investment decisions
CO 4 Differentiating the different investors' Analyze
behaviour in Indian Financial Markets
using segmentation
CO 5 To evaluate investment decisions by Application
retail investors using emerging trends in
financial markets
Unit – II: Behavioral Factors explaining Stock Market Puzzles!!

CO3: To analyze the effect of different Behavioural influences on various

investment decisions.

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 Introduction: THE EQUITY PREMIUM PUZZLE
• The focus will be on three puzzles: the equity premium puzzle; bubbles; and
excessive volatility.
• We begin in Section with the equity premium puzzle, namely the
observation that, while equities are riskier than fixed-income securities and
as a result should earn higher average returns in compensation for the
additional risk borne, it is apparent that the historical gap between stock
and bond returns is implausibly high from the standpoint of expected utility
theory.
• Next we turn to overvaluation and bubbles, beginning in Section with two
famous overvaluation episodes, the tulip mania, which occurred in Europe
close to 400 years ago, and the tech/Internet bubble that occurred in world
stock markets in the late 1990s.
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 Introduction
• Focusing on the United States, while the entire stock market likely deviated
far from valuations based on economic fundamentals, much of the
overvaluation was concentrated in tech and Internet stocks.
• One problem with looking at real-world data is that it is always difficult to
categorically say that an episode of overvaluation is occurring.
• Because of the ability to carefully control the environment, experimental
asset markets, as reported in Section, provide insight into the conditions
under which asset price bubbles are generated.
• In next Section, we consider whether behavioral finance can contribute to
an understanding of overvaluation episodes, including asset price bubbles.

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 Introduction
• Finally, in next Section, we turn to the puzzle that stock market prices
seem to exhibit too much volatility.
• This has long been a contentious point, but as of early 2009 has taken
on even greater resonance as amazingly high levels of volatility have
been observed along with dramatic declines in asset values.
• The chapter concludes, in final Section, with a tentative interpretation
of events that roiled markets in 2008.

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I: THE EQUITY PREMIUM PUZZLE

• Much research has examined the equity premium puzzle, which was
forcefully brought to light by Rajinish Mehra and Edward Prescott.1
The equity premium is defined to be the gap between the expected
return on the aggregate stock market and a portfolio of fixed-
income securities. Since no one can easily observe expected returns,
we approximate the equity premium using historical average
returns. On this basis, the equity premium can be calculated in a
number of ways: it depends on whether you use arithmetic versus
geometric average returns, the sample you employ, and what your
market and fixed-income proxies are.

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I: THE EQUITY PREMIUM PUZZLE

• There is no right answer, so it is useful to calculate the equity

premium in different ways. Jeremy Siegel in his best-selling book
Stocks for the Long Run provides a wealth of data on the equity
premium. What is very nice about his dataset is that it goes all the
way back to 1802. While the sample ends in 1997, given its long
history, it is still quite useful today.

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I: THE EQUITY PREMIUM PUZZLE

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I: THE EQUITY PREMIUM PUZZLE

• Figure 14.1 asks the following question: If you began with $1

invested in a particular asset class and “let it ride,” how much would
you (or, more accurately, your heirs) have by 1997? The asset classes
examined are U.S. stocks, bonds, Treasury bills, and gold. Incredibly,
your $1 investment in stocks would have surpassed $7 million—not
bad for the patient investor. Bonds would be worth over $10,500
and T-bills over $3,500. Of course, $1 in 1802 bought a lot more
than it does today. For reference purposes, the figure also shows the
rise in prices (as proxied by the Consumer Price Index, or CPI).

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I: THE EQUITY PREMIUM PUZZLE

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• To control for price changes, Figure 14.2 restates Figure 14.1, but now all returns
are on a real (or constant-dollar) basis.
• Stocks are tamed to some extent, but a $1 investment still grows to over $550,000,
versus less than $1,000 for bonds and bills, and (perhaps surprisingly to some) less
than $1 for gold. In Table 14.1, we convert everything into average (annual) returns.
• Real returns are presented both for the full sample and for three roughly equal
subperiods. Beginning with stocks, the average returns on stocks have been fairly
stable.
• Using the more conservative geometric average measure, long-term averages have
ranged from 6.6% to 7.2%. The comparable numbers for bonds and bills have been
2%–4.8% and 0.6%–5.1%.
• If we choose the lowest full-sample equity premium, it is 3.5% (stocks vs. bonds
using the geometric average).
• For the most recent subperiod, which begins in 1926, this same gap is 5.2%.

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 WHY IS THE EQUITY PREMIUM A PUZZLE?

• Is the equity premium really a puzzle? Stocks after all are riskier, so they
should earn higher returns.
• The reason a puzzle exists is that, assuming expected utility theory
applies, an implausibly high level of risk aversion would have to be
assumed to rationalize these numbers.
• This can be seen in a number of ways. First, Mehra and Prescott argue
that a reasonable level of risk aversion would lead to an equity premium
of 0.1%.
• Second, recalling discussion of utility functions and again using the
popular logarithmic function, the coefficient of relative risk aversion, one
measure of distaste for risk, is 1.0.4
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 WHY IS THE EQUITY PREMIUM A PUZZLE?
• Higher numbers indicate more risk aversion.
• The coefficient of relative risk aversion needed to justify the observed
equity premium would have to be a whopping 30 in order to explain
observed returns!
• Third, recalling prospects and certainty equivalents, consider the following
prospect: P1(0.50, $50,000, $100,000).
• What certainty equivalent, $x, would make someone indifferent between
P1 and this certain amount of money?
• For someone with a coefficient of relative risk aversion of 30, $x would
need to be $51,209.5 It seems unlikely that people are that afraid of risk.
•
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 WHAT CAN EXPLAIN THIS PUZZLE?
• There is much debate on what accounts for observed equity premiums.
Some explanations are based on rationality, and some take a more
behavioral approach.
• As an example of the former, it has been suggested that survivorship
bias may contribute to an understanding of the puzzle. To put this
explanation into perspective, consider the following sports example.
• In golf tournaments, typically a group of players shoots two rounds. All
players in the group with the lowest cumulative score (up to some
predetermined number of players) continue on to play the third and
fourth rounds.
• The surviving player with the lowest four-round total wins the
tournament. Let’s say a statistician comes along and wants to estimate
the average performance of all golfers.

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WHAT CAN EXPLAIN THIS PUZZLE?
• He shows up at the end of the tournament and calculates the
average score per round of all surviving golfers.
• Clearly this would be biased downward. As an illustration, we
conducted the following simple experiment.
• We simulated a hypothetical tournament with 100 players, using the
assumptions that all players have equal skill and there is
independence among rounds.
• The latter is tantamount to the non-existence of a “hot hand effect.”
• A distributional mean of 71 and a standard deviation of 3 were
assumed.

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WHAT CAN EXPLAIN THIS PUZZLE?
• Then, after two rounds we took the top half (and ties) of all golfers
and let them continue on to play the last two rounds.
• The rest of the golfers did not make the cut. The average score per
round for all surviving golfers was 70.1—about a stroke below the
distributional mean.
• In contrast, the average score over the first two rounds for all 100
golfers was 70.9—very close to the distributional mean.
• A researcher does not want to make the mistake of only looking at
survivors.

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• In the context of the equity premium puzzle, Stephen Brown,
William Goetzmann, and Stephen Ross looked at performance
histories of national stock markets around the world.
• As of the beginning of the twentieth century, 36 national stock
markets existed. More than half of these, either due to wars or
nationalizations, have suffered at least one major break in trading.
• These events often result in very large losses in wealth for investors.
• But if we only look at the roughly half of all national markets with
continuous trading histories, the golf example makes it clear that
the average market return will be upward-biased because of
survivorship bias.
• On the behavioral side, there are two main explanations.

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• One is based on ambiguity aversion.
• The equity premium puzzle suggests that required risk aversion is
simply too high to be credible.
• But what if people are both risk averse and ambiguity averse?
• Not only do investors, naturally enough, not know what the random
draw from the return distribution will be, but they also do not know
what the distributional parameters themselves are.
• This is consistent with survey evidence showing wide disagreement
on the level of the ex-ante equity premium, which means that we
don’t know the mean of the return distribution.

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• Under such circumstances, “effective risk aversion” increases.10
Assuming plausible values for risk aversion and ambiguity aversion
(or uncertainty aversion), an equity premium in the neighborhood of
5% turns out to be quite reasonable.
• A second behavioral explanation for the equity premium puzzle, as
proposed by Shlomo Benartzi and Richard Thaler, is based on loss
aversion and mental accounting.
• Recall that people who are loss averse feel losses much more than
gains of equivalent size.

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• The two-part power function described in a popular prospect theory
value function. It is reproduced here, where v is value and z is change in
wealth:
υ(z) = zα 0<α<1 if z ≥ 0
−λ(−z)β >1; 0<β<1 if z < 0
• This function exhibits risk aversion in the positive domain (0 < α < 1), risk
seeking in the negative domain (0 < β < 1) and loss aversion (λ > 1). All we
need, however, for present purposes is loss aversion, so, if we set α = β =
1, we have the following “kinked” linear function:
υ(w) = z if z ≥ 0
λz λ > 1 if z < 0
•

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• This function says that people are risk neutral once they are away
from the reference point. In the equation below we will assume λ =
2.5.12
• Another complication of prospect theory is the weighting function,
but once again we can keep matters simple and assume that, as in
the case of expected utility, weights and probabilities are equivalent.

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 Mental accounting is also assumed.
• mental accounting involves separating blocks of information into more
manageable pieces.
• This concept is significant because how people aggregate information
has an effect on how the information is evaluated.
• When people hold portfolios, it is natural that for a while they do not
monitor things too carefully.
• By this we mean that they do not pay too much attention to precise
losses or gains.
• For this reason, short-term market value changes are effectively
integrated.
• Periodically, however, people will look at their portfolios more carefully.
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• They will note whether they have made gains or losses. At this point,
in the parlance of mental accounting, they will “book their losses.”
• In this sense, they are segregating the past from the future.
• Since people don’t like losses, they are likely ex ante to avoid
investments that have an uncomfortably high probability of ending
up in negative territory when it is time for portfolios to be
evaluated.

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• Consider the following prospect: P2(0.50, $200, -$100).
• Would someone with the previous value function accept this
prospect or prefer to do nothing?
• Think of this prospect as an investment where one can make $200
or lose $100.
• In other words, noting that the expected gain is $50, is the risk of
the investment worth the potential gain?
• On a one-shot basis, the answer is no, since, as shown in this
example, the value of this prospect is zero:
• V(P2) = 0.50(200) + 0.50(2.5(−100)) = −25

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• What if the prospect is allowed to be run twice before the investor
carefully notes the result?
• In other words, she integrates two prospects until she looks closely at
the result, at which point segregation occurs.
• In this case, this investor would take two of these gambles.
• The possible outcomes after two gambles are $400 with a probability
25%, $100 with a probability of 50%, and −$200 with a probability of
25%.

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• First note that two runs of P2 lead to: P3(0.25, .50; $400, $100, −$200).
• In this straightforward extension of the previous prospect notation, the first two
numbers are probabilities that should be associated with the first two wealth
outcomes (to the right of the semicolon), while the residual probability should
be associated with the third wealth outcome.
• The value of P3 is:
• V(P3) = 0.25(400) + 0.50(100) + .25(2.5(−200)) = 25

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• Note that now a loss is only half as likely (25% vs. 50%) to occur.
• While this person remains loss averse, she is now more willing to
take the risk of the investment as long as she evaluates the
outcomes two prospects at a time.
• This is tantamount to looking at one’s portfolio every two periods.

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 References
• WebLinks
• https://www.researchgate.net/publication/5161957_A_Behavioural_Approach_To_Financial_Puzzl
es
• https://slidetodoc.com/do-behavioral-factors-explain-stock-market-puzzles-1/
• https://scholar.harvard.edu/files/shleifer/files/bgls_may25.pdf
• https://www.investopedia.com/terms/e/epp.asp

• References
• Ackert, L. and Deaves, R. (2115). Behavioral Finance. Ist Ed. Mason, OH: South-Western Cengage
Learning. ISBN: 978-0-324-66117-0.
• Pompian, M. 2106. Behavioral Finance and Wealth Management.Ist Ed. Wiley: New Jersey. ISBN: 0-
471-74517-0.

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