The study of happiness & the equity premium controversy

Rational investors

Rational behavior in economics and finance - Axioms of utility:● Utility is driven by wealth● Risk aversion● Decreasing marginal utility● Transitivity● Comparability● Measurability

In a more general way, individuals should display attitudes, beliefs, andpreferences that:

● Adhere to logic and probability theory● Be coherent● Not be changed based on irrelevant factors● Be compatible with empirical observations available to the individual

Does money bring happiness?

Self-assessed happiness varies cross-sectionally with GDP (source: Inter-American Development Bank, “Beyond Facts: Understanding Quality of Life,” 2005-2007)

Decision utility test

Choose between:

A: your job pays $35,000; similar co-workers earn $58,000

B: your job pays $33,000; similar co-workers earn $30,000

World Happiness Survey(White, A. G.(2007) “A Global Projection of Subjective Well-being: A Challenge To Positive Psychology?” Psychtalk 56, 17-20)

Happy Planet Index (New Economic Foundation 2006)

Where-to-be-born-index(Economist Intelligence Unit 2013)

World Happiness Report and Rankings(University of British Columbia and The Canadian Institute for Advanced Research 2010-2012)

Gore Vidal: “...it is not enough to succeed. Others must fail.”

Beyond and above the poverty level, self-assessed satisfaction is not much correlatedwith income.

Self-assessed satisfaction is correlated, however, with perceived income inequalities

Inter-temporal trends: A few facts

Tremendous growth in the last 50-100 years:● Level of income● Standard of material living and consumption● Level of general health● Life expectancy ● Level of education ● Leisure● Choice● Democracy and freedom

The average European and North-American individual has a higher standard of(material) living today than the King of England in the18th century

The average European and North-American individual has a higher standard of(material) living today than 50 or 30 years ago

Yet, the level of self-assessed satisfaction has not changed in more than50 years

Projecting utility

(i) How happy would you be if you if you won a $15,000,000 lottery ? (on a scale from 1 to 10)

For how long? (in years)

(ii) How distressed would you be if you were involved in a car accident that leftyou paralyzed from the waist down ? (on a scale from 1 to 10)

For how long? (in years)

We fail to correctly anticipate future emotional states.

The treadmill effect

'Keeping up with the Jones'

Aspiration and expectations increase with status and success - treadmill orratchet effect

Utility – A tragedy in three actsSteven Pinker (1997) How the mind works

Comparison with others – everything depends on your relative position

Inter-temporal comparison – in the long-run, happiness (utility) reverts to a“normal” state

Loss-aversion is stronger than the joy of gaining

Paul Piff:http://www.ted.com/talks/paul_piff_does_money_make_you_mean

What do we perceive as causes of satisfaction and happiness?

● Social status● Relationships● Love● Family and children● Reputation● Meaning● Choice ● Income

Income and wealth represent a proxy for other variables (ex: social status,relationship, children, reputation, etc.)

Proximate motives: social status, relationship, children, reputation, etc.Ultimate motives: survival and reproduction

● Why social status? In most societies, higher social status gives males more accessto females of reproductive age (higher social status = more sex)

● Why relationships? It allows both males and females to raise children● Why reputation? It makes an individual a more desirable social and economic

partner

The Economics of Satisfaction

What makes us happy - nature vs. nurture:● Genetic inheritance● Environmental factors

Identical twins separated at birth: More than 50% of the variation in tastes, personality, and disposition tohappiness is due to genetic factors

Environmental factors that contribute to happiness:● Level of income – up to the poverty level● Perceived income disparities● Level of stress● Exposure to sunlight (has an impact on brain serotonin)● Etc.

Happiness gene?Eugenio Proto and Andrew J. Oswald (2014) “National Happiness and Genetic Distance: A Cautious Exploration,” working paper

Denmark and other Scandinavian countries have been historically the (self-reported) happiest countries in the world.

Swedes, Norwegians, and Finns are genetically the most closely related toDanes

The least genetically related to Danes ethnic groups are also the least happy(after controlling for GDP per capita, and other economic and social factors)

The research looked at the relationship between people's (perceived) well-beingand the mutation of a gene (5-HTTLPR ) that governs serotonin

In the US, the happier individuals are descendants from Danes and Swedes,and they too carry a close mutation of the (5-HTTLPR ) gene that governsserotoninGenes and life-style play a role in our cholesterol levels, obesity, heart-disease,cancer, mood disorders, etc. Why would happiness be any different?

Standard economics and finance

RationalityUtility and satisfaction = function (level of wealth)Clear separation between investing and consumptionPrice of financial securities = as a function of information and future returnsPrice of consumer goods = as a function of pure satisfaction

What if utility, satisfaction, and happiness were dispositional traits rather than areaction to external events (Costa and McRae 1984; Lykken and Tellegen 1996)

Implications: Why and how individuals pursue returns

It's the journey, not the destination

People who are focused more on the meaning of what they do rather than onattaining an objective (happiness) are also happier

Too much (hedonic) introspection has an adverse impact on perceived well-being – people find cartoons less funny when asked to reflect on why they findthem funny.

Is it introspection that causes lack of satisfaction or is it that less satisfiedpeople have more reasons to reflect on their (unhappy) condition?

Dan Gilbert:http://www.ted.com/talks/dan_gilbert_asks_why_are_we_happy

Coincidence? Implications for shareholder wealth

Frequent (and compulsive) evaluation of earnings targets, and returnperformance tends to defeat the purpose of value creation

Companies that do not keep on evaluating their earnings targets and marketperformance do not perform worse than those who do: see the 1999 (former)Daimler-Chrysler merger

Chrysler used to report (quarterly) earnings targets and estimatesDaimler did not

Historical returns

Warren Buffet on stock returns:https://www.youtube.com/watch?v=vl2aP8dlIn4

The Equity Premium Controversy

Source: Rajnish Mehra (2003) THE EQUITY PREMIUM: WHY IS IT A PUZZLE?

Why is it a puzzle?

The difference is historical returns between relatively “risk-free” assets and equity is too largeIf investors have rational expectations, optimized low risk portfolios should lie on the efficient frontierSource: Pimco

The equity premium “puzzle”

Over more than the last century, T-bills have returned about 1% annually, whileequities have returned between 7% and 8% annually

Equity premium: over 7% annually Stocks are riskier than bonds, but....... the difference in the volatility of returns and relative risk (with respect to themarket portfolio, of course) does not justify this large equity premium.

Findings

On average, investors tend to sell “winners” (to lock-in the profits), and keep the“losers” (in the hope to recover) – the disposition effect

The equity premium is proportional to the number of time investors (re)-evaluate their portfolios

Investors who constantly re-balance their portfolios– including professionalinvestors – depress the value of the assets most likely to appreciate in value andbid-up the value of relatively risk-free securities