How the Risk Premium Factor Model and Loss Aversion Solve the Equity Premium Puzzle

The term “equity premium puzzle” was coined in 1985 by economists Rajnish Mehra and Edward C. Prescott. The equity premium puzzle in considered one of the most significant questions in finance. A number of papers have explored the fundamental questions of why the premium exists and has not been arbitraged away over time. This paper expands upon the findings implicit in the Risk Premium Valuation Model (Hassett 2010) that the equity risk premium is a function of risk free rates. Since 1960 the equity risk premium has been 1.9-2.48 times the risk free rate. The long term consistency of this relationship with loss aversion coefficients associated with Prospect Theory (Kahneman and Tversky, 1979) suggest it as a solution to the equity premium puzzle and support the experimental findings of Myopic Loss Aversion (Thaler, Tverseky, Kahneman and Schwartz, 1997)