help explain the volatility puzzle, although we argue later that models with
irrational beliefs also offer a plausible way of thinking about the data.
Both the rational and behavioral approaches to finance have made
progress in understanding the three puzzles singled out at the start of this
section. The advances on the rational side are well described in other
articles in this handbook. Here, we discuss the behavioral approaches,
starting with the equity premium puzzle and then turning to the volatility
puzzle.
We do not consider the predictability puzzle separately, because in any
model with a stationary P/D ratio, a resolution of the volatility puzzle is si-
multaneously a resolution of the predictability puzzle. To see this, recall
from Eq. (8) that any model which captures the empirical volatility of re-
turns must involve variation in the P/D ratio. Moreover, for a model to be a
satisfactoryresolution of the volatility puzzle, it should not make the coun-
terfactual prediction that P/D ratios forecast subsequent dividend growth.
Now suppose that the P/D ratio is higher than average. The only way it can
return to its mean is if cash flows Dsubsequently go up, or if prices Pfall.
Since the P/D ratio is not allowed to forecast cash flows, it must forecast
lower returns, thereby explaining the predictability puzzle.
4.1. The Equity Premium PuzzleThe core of the equity premium puzzle is that even though stocks appear to
be an attractive asset—they have high average returns and a low covariance
with consumption growth—investors appear very unwilling to hold them.
In particular, they appear to demand a substantial risk premium in order to
hold the market supply.
To date, behavioral finance has pursued two approaches to this puzzle.
Both are based on preferences: one relies on prospect theory, the other on
ambiguity aversion. In essence, both approaches try to understand what it
is that is missing from the popular preference specification in Eq. (6) that
makes investors fear stocks so much, leading them to charge a high pre-
mium in equilibrium.
4.1.1. prospect theoryOne of the earliest papers to link prospect theory to the equity premium is
Benartzi and Thaler (1995), BT henceforth. They study how an investor
with prospect theory-type preferences allocates his financial wealth be-
tween T-Bills and the stock market. Prospect theory argues that when
choosing between gambles, people compute the gains and losses for each
one and select the one with the highest prospective utility. In a financial
context, this suggests that people may choose a portfolio allocation by
computing, for each allocation, the potential gains and losses in the value
of their holdings, and then taking the allocation with the highest prospective
26 BARBERIS AND THALER