An individual faces the following to investment options:
Investment A: buy a stock fund that every year either earns 50% with a probability of 60% or loses -25% with a probability of 40%.
Investment B: buy a bond that returns 5% with a probability of 50% or 0% with a probability of 50%.
Assume that the returns of the two funds are independent and that returns from year to year are also independent. Also, assume an initial investment of £1.
The value function of the individual is specified as:
V(z)=z for z>0
V(z)= 3.5z for z<0
1) Which investment option would the investor choose if he looks at the investment once per year?
2) Which investment option would the investor choose if he looks at the investment once every two years?
3) Discuss the term “Myopic loss aversion”
4) Explain the equity premium puzzle. Why is it deemed to be a puzzle?
5) How can myopic loss aversion explain the equity premium puzzle?