Behavioral risk premium

Anyone who has traded – not on hypothetical papers but in the real world – with real money at stake and deep-seated emotions stirred, will immediately recognize that it is difficult, in the heat of battle, not to buy at the top just as it is difficult not to sell (or to buy) at the bottom. In the real world, no one buys into the market at or near the top expecting a lower return. No! At the top, the expected return for many if not most (or average) participants is high, just as at the bottom participants dump shares willy-nilly because they expect a low (or negative) return and decide they had better sell before prices drop and the expected returns deteriorate still further.

These behavioral aspects are in direct opposition to the dominant theories of modern finance, which posit that investors follow a rational expectations model, equilibrium is always near, and arbitrage is smooth and riskless. Therefore, as neat and interesting as the coldly precise standard theory has proven to be, it still appears to be missing something when it comes to describing bubbles and baths (crashes). The following sections will attempt to demonstrate that the equity risk premium that is retrospectively measured may actually contain what is called a behavioral risk premium component.