The Loss Aversion / Narrow Framing Approach to the Equity Premium Puzzle

We review one recent approach to the equity premium puzzle. The key elements of this approach are loss aversion and narrow framing, two well-known features of decisionmaking under risk in experimental settings. In equilibrium, models that incorporate these ideas can generate a large equity premium and a low and stable risk-free rate, even when consumption growth is smooth and only weakly correlated with the stock market. Moreover, they can do so for parameter values that correspond to sensible predictions about attitudes to independent monetary gambles. The analysis for the equity premium also has implications for a closely related portfolio puzzle, the stock market participation puzzle. We suggest some possible directions for future research. ∗This essay is being prepared for the Handbook of Investments: Equity Premium, edited by Rajnish Mehra. We thank Raj Mehra for inviting us to contribute a chapter, and are grateful to him for valuable feedback. Comments are welcome at [email protected] and [email protected].