Francis Larson, John A. List, and Robert D. Metcalfe, “Can Myopic Loss
Aversion Explain the Equity Premium Puzzle? Evidence from a Natural
Field Experiment with Professional Traders.” August 31, 2016; available here.
• The puzzle: the real return on US equities is about 8% per annum, versus about 1% for riskless assets. This spread cannot easily be explained as a risk premium.
• One hypothesis: traders display myopic loss aversion (MLA), and hence the frequent downticks (short-term declines in asset value) are psychologically costly – people will only put up with these costs if there is an offsetting premium in the monetary return. If MLA can explain the equity premium puzzle, then it must be present in the “marginal” trader.
• Laboratory experiments have found that myopic loss aversion is common. The standard design involves varying the rate at which price information is delivered to traders. Those who receive information at high frequency are exposed to more revelations of downticks, and hence, if they display MLA, they will underinvest in the risky asset, the one that is subject to lots of downticks.
• The Larson, List, and Metcalfe paper employs a (natural?) field experiment, where traders do not know they are taking part in an experiment; they think they are beta-testing a new online trading platform.
• The traders' recompense is to be paid eventually in-kind based on the profits that they accrue during their two weeks of testing. They can “buy” a risky asset whose return is tied (in a not-fully-obvious way) to the US dollar exchange rate. The tying is such as to bias the return to the asset to be positive.
• The experiment reveals MLA – traders who are given infrequent (once per 4 hours) price updates keep more of their stake in the risky asset, and earn considerably more, than those traders who receive second-by-second updates.
• Traders tend to desire more frequent price updates, but perhaps that information degrades their performance.
• Since both the Frequent (n=73) and Infrequent (n=78) groups of traders can trade at any time, this experiment avoids a confounding feature of past laboratory experiments, that both information and trade opportunities are altered among conditions.
• The puzzle: the real return on US equities is about 8% per annum, versus about 1% for riskless assets. This spread cannot easily be explained as a risk premium.
• One hypothesis: traders display myopic loss aversion (MLA), and hence the frequent downticks (short-term declines in asset value) are psychologically costly – people will only put up with these costs if there is an offsetting premium in the monetary return. If MLA can explain the equity premium puzzle, then it must be present in the “marginal” trader.
• Laboratory experiments have found that myopic loss aversion is common. The standard design involves varying the rate at which price information is delivered to traders. Those who receive information at high frequency are exposed to more revelations of downticks, and hence, if they display MLA, they will underinvest in the risky asset, the one that is subject to lots of downticks.
• The Larson, List, and Metcalfe paper employs a (natural?) field experiment, where traders do not know they are taking part in an experiment; they think they are beta-testing a new online trading platform.
• The traders' recompense is to be paid eventually in-kind based on the profits that they accrue during their two weeks of testing. They can “buy” a risky asset whose return is tied (in a not-fully-obvious way) to the US dollar exchange rate. The tying is such as to bias the return to the asset to be positive.
• The experiment reveals MLA – traders who are given infrequent (once per 4 hours) price updates keep more of their stake in the risky asset, and earn considerably more, than those traders who receive second-by-second updates.
• Traders tend to desire more frequent price updates, but perhaps that information degrades their performance.
• Since both the Frequent (n=73) and Infrequent (n=78) groups of traders can trade at any time, this experiment avoids a confounding feature of past laboratory experiments, that both information and trade opportunities are altered among conditions.
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