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The Risk Premium Factor: A New Model for Understanding the Volatile Forces that Drive Stock Prices by Stephen D. Hassett

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Chapter 3

Solving the Equity Premium Puzzle

The Link to Loss Aversion

The Risk Premium Factor (RPF) Model solves the equity premium puzzle by demonstrating that varying the equity risk premium (ERP) with the risk-free rate is consistent with prospect theory and loss aversion.

The equity premium puzzle in considered one of the most significant questions in finance. The term equity premium puzzle was coined by Mehra and Prescott in their 1985 paper, “The Equity Premium, A Puzzle,”1 referring to the inability to reconcile the observed ERP with financial models. In the analysis, they use short-term Treasuries as the risk-free rate to calculate the real return on equities over numerous historical periods. They conclude that, on average, short-term Treasuries have produced a real return of about 1 percent over the long term, while equities have yielded 7 percent, implying a premium of about 6 percent or seven times the risk free return. Unable to reconcile a 7× premium with financial models, they term it a puzzle.

Since then, numerous papers have also attempted to explain the difference, including Benartzi and Thaler's “Myopic Loss Aversion and the Equity Premium Puzzle,”2 which attempts to explain it in relation of loss aversion as first described in a paper by Daniel Kahneman and Amos Tversky in 1979.3 They state:

The second behavioral concept we employ is mental accounting [Kahneman and Tversky 1984; Thaler 1985]. Mental accounting refers to the implicit methods individuals use to ...

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