BProspect theory — the value function is concave for gains (risk-averse, so lock in gains) and convex for losses (risk-seeking, so gamble on recovery), with the purchase price as the reference point
CEfficient market theory — the market correctly prices the stocks
DHerding behavior — investors follow what others are doing
The disposition effect directly follows from prospect theory. The purchase price serves as the reference point. For stocks that have appreciated (in the gain domain), the concave value function produces risk aversion — sell now to lock in the certain gain. For stocks that have declined (in the loss domain), the convex value function produces risk seeking — hold on in hopes of recovery rather than accepting the certain loss. Tax optimization would predict the opposite behavior (selling losers for tax loss harvesting), making the disposition effect tax-inefficient.
Question 2 True / False
The efficient market hypothesis and behavioral finance are completely incompatible theories that cannot coexist.
TTrue
FFalse
Answer: False
The relationship is more nuanced. Behavioral finance identifies systematic investor biases that can create mispricings, but markets may still be 'approximately efficient' if arbitrage activity corrects mispricings quickly. Limits to arbitrage (short-selling constraints, noise trader risk, capital constraints) explain why some mispricings persist. A moderate view holds that markets are generally efficient for large, liquid securities but can exhibit persistent behavioral anomalies in specific contexts. Behavioral finance refines rather than replaces efficient market theory.
Question 3 Short Answer
What is the equity premium puzzle, and how does behavioral finance explain it?
Think about your answer, then reveal below.
Model answer: The equity premium puzzle (Mehra & Prescott) is the observation that the historical return premium of stocks over bonds (~6% annually in the US) is far larger than standard models with reasonable levels of risk aversion can explain. Benartzi and Thaler's myopic loss aversion explanation proposes that investors evaluate their portfolios frequently (e.g., annually), and because stocks have more short-term losses than bonds, loss-averse investors demand a high premium to tolerate the frequent experience of losses. If investors evaluated portfolios less frequently, the apparent riskiness of stocks would decrease.
The key insight is that the premium depends not just on objective risk but on how investors experience risk. Loss aversion (losses hurt ~2x as much as equivalent gains) combined with narrow framing (evaluating returns over short periods rather than long horizons) and myopia (checking the portfolio frequently) produces far more loss-related disutility from stock holding than standard risk aversion can generate. Extending the evaluation period from 1 year to 20 years dramatically reduces the frequency of observed losses, which would reduce the required premium.