00Thaler_FM i-xxvi.qxd

As described in section 2, we suppose that the investor uses the risk-free
rate as a reference level when calculating gains and losses. Table 7.11 stud-
ies the sensitivity of our results to that assumption. Given the parameter
values in table 7.3, the risk-free rate is Rf− 1 =3.86 percent. The table
shows the effect of using a reference level that is one or two percentage
points lower than this. Note that the equity premium falls as we use a lower
reference level: a lower reference point means that the investor is less likely
to code stock market movements as losses, and hence less inclined to charge
a high premium for holding stocks.

6 .The Importance of Prior Outcomes

The model in section 2 makes use of both loss aversion and the effect of prior
outcomes to match asset prices. The reader may wonder whether boththese

260 BARBERIS, HUANG, SANTOS

Table 7.9

Sensitivity of Asset Returns to η

Empirical

η= 1 η=0.9 η=0.8 Value

Log excess stock return
Mean 7.68 5.02 3.91 6.03
Standard deviation 34.54 23.84 19.12 20.02
Sharpe ratio 0.22 0.21 0.2 0.3
Autocorrelation of price/
dividend ratio 0.81 0.72 0.65 0.7
Average loss aversion 4.5 3.5 3.0

The parameter ηgoverns how long-lasting the effects of prior gains and losses are. Mo-
ments of asset returns are expressed as annual percentages. The results are for Economy II
with b 0 =2 and k=10; other parameters are fixed at the values in table 7.3.

Table 7.10

Sensitivity of Asset Returns to the Evaluation Period

Empirical

6 months 1 year 2 years Value

Log excess stock return
Mean 7.63 5.02 2.85 6.03
Standard deviation 27.78 23.84 20.15 20.02
Sharpe ratio 0.27 0.21 0.14 0.3
Average loss aversion 3.5 3.5 3.6

The evaluation period is the length of time over which the investor measures his gains and
losses. Moments of asset returns are expressed as annual percentages. The results are for Econ-
omy II with b 0 =2 and k=10; other parameters are fixed at the values in table 7.3.