Aggregate Stock Market

equity premium puzzle

-if people are risk averse, market price / return will be higher The return on equities has been about six percent higher than the return on T-bills since 1928 -people are overcompensated by the market compared to the risk they are taking

four drivers of stock market fluctuations in an economy with rational investors: (rational approach)

1. changes in (rationally) forecasted future cash flows 2. changes in (rationally) forecasted future interest rates 3. changes in (rationally) forecasted future risk 4. changes in investor risk aversion ("price of risk") -tough to explain the stock market volatility with this approach

Why is it that long maturity cash flows should have a higher risk premium than short duration cash flows in the habit formation model?

Dividends growth increases => Consumption increases => Risk-aversion decreases => Prices increase (more so for long-term claims) Since prices are positively related to consumption shocks, positive risk-premium (higher risk-premium for long term claims)

changes in price of risk could explain the stock market fluctuations...why is this?

People do not want to give up the standard of living to which they have become accustomed As they get wealthier, risk-aversion decreases As they get poorer, risk-aversion increases The "habit-formation" framework

stock market volatility

US stock market historically volatile

If (rationally) forecasted future cash flows are the source:

Years of low (high) P/E ratios should be followed by low (high) earnings growth we see that P/E ratio and future cash flow lack correlation, so this is NOT the source of stock market fluctuations

very difficult to explain the equity premium puzzle in a standard rational model. What does it require instead?

an absurd level of risk aversion Having a habit level, amplifies consumption changes: Δ(𝑐−ℎ) /𝑐−ℎ > Δ(𝑐) / 𝑐

The term structure of holding-period equity returns is on average _____________ sloping!

downward e(r) on LT > e(r) on short-term BUT short-term dividend strips earn more than long-term equities

prospect theory's loss aversion

drives people from the stock market -Investors find a loss more painful than an equally sized gain pleasurable -An investment in equities sees more losses than T-bill investments

overextrapolation states that investors incorrectly...

expect the market to rise after increases in the stock price, and they expect the market to fall after decreases in the stock price -If the stock market performs well (poorly), investors think it will continue to perform well (poorly) and push prices even higher (lower) - this leads to excess volatility -pushes price up and down

horizon bias with term structure of equity returns

investors are more optimistic at long horizons relative to short horizons -investors may put more money in risky funds despite no change in risk, therefore they are willing to pay more -degree of the horizon bias predicts realized equity term structure

The more often you check your portfolio, the more you may dislike equity investments. Why?

mental and financial health -increased stress and impulsivity -Investors who check their portfolios often will perceive investing to be riskier than investors who don't (letting your emotion take control) related to loss aversion

habit formation model

process by which new behaviors become automatic -consumers' utility depends in part on current consumption relative to past consumption

Can think of the equity market as the discounted sum of all future dividend payments... Long duration of equity makes prices sensitive to ... Long maturity cash flows should have a higher risk premium than...

sensitive to small persistent movements in the price of risk than short duration cash flows in the habit formation model.

overextrapolation is related to...

the law of small numbers

term structure of risk aversion: we are more risk averse @....

the short horizon

rational approach to stock market volatility

typically thinks that the price equals expected future cash flows discounted at a sensible rate r r = risk free + (risk)(price of risk) -tough to explain the stock market volatility with this approach