Evolved attitudes to risk and the demand for equity

The equity premium puzzle refers to the observation that people invest far less in the stock market than is implied by measures of their risk aversion in other contexts. Here, we argue that light on this puzzle can be shed by the hypothesis that human risk attitudes were at least partly shaped by our evolutionary history. In particular, a simple evolutionary model shows that natural selection will, over the long haul, favor a greater aversion to aggregate than to idiosyncratic risk. We apply this model—via both a static model of portfolio choice and a dynamic model that allows for intertemporal tradeoffs—to show that an aversion to aggregate risk that is derived from biology may help explain the equity premium puzzle. The type of investor favored in our model would indeed invest less in equities than other common observations of risk-taking behavior from outside the stock market would imply, while engaging in reasonable tradeoffs over time.

Solution to the Equity Premium Puzzle

This study provides a solution of the equity premium puzzle. Questioning the validity of the Arrow-Pratt measure of relative risk aversion for detecting the risk behavior of investors, a new tool in the form of the sufficiency factor of the model was developed to analyze the risk behavior of investors. The calculations of this newly tested model show that the value of the coefficient of relative risk aversion is 1.033526 by assuming the value of the subjective time discount factor as 0.99. Since these values are compatible with the existing empirical studies, they confirm the validity of the newly derived model that provides a solution to the equity premium puzzle.