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Behavioural Finance

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The equity premium puzzle Mehra and Prescott (1985) found that between 1926 and 1985, the premium between risky and riskfree assets was on average about 6% per year. In order to be able to explain this equity premium within a rational framework, an unrealistically high degree of risk aversion had to be assumed. Mehra and Prescott showed that, in a model where individuals aim at smoothing consumption, the coefficient of relative risk aversion would need to exceed 30 to account for the equity premium. With reference to relevant literature and empirical studies, critically evaluate why this is a puzzle. Does behavioral theory offer a better explanation to this phenomenon?
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WOODLANDS DRIVE 42, Singapore
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