The equity premium puzzle is one of the most important phenomena in finance. Related to behavioral finance, we use the concept of Myopic Loss Aversion (MLA) to explain the puzzle in developed and emerging markets. Empirically, we support the robustness of the positive equity premium across the most developed and emerging markets before the subprime crisis. However, the equity premium becomes negative during the subprime crisis, except for the financial markets of Hong Kong, India and Tunisia. Using a simulation method, we find that myopic emerging and developed market investors evaluate their portfolios annually. Furthermore, the optimal stocks allocation by myopic loss-averse investors is higher in emerging markets than in the developed markets.

Expected utility theory, a predominant framework for modeling decision making under risk, typically assumes that agents make rational choices, evaluate wealth according to final asset positions and evaluate probability objectively. However, substantial experimental evidences have indicated that agents fail to follow the assumptions of expected utility theory. In fact, they violate risk preference assumptions when facing uncertainties. As a consequence, alternative models have been developed by behavioral finance researchers.

The field of behavioral finance is very relevant for better studying and understanding human judgment. Behavioral models like Prospect Theory (PT), developed by Kahneman and Tversky (1979), infuse a more realistic assumption of investor behavior. In 1992, Tversky and Kahneman extended the PT framework and developed a new version of PT called Cumulative Prospect Theory (CPT).

PT arguments have been increasingly used to explain a range of anomalies observed in financial markets like the disposition effect, momentum (Menkhoff and Schmeling, 2006), excess of volatility, stock return predictability, and the trading behavior. More specifically, CPT has an important impact on empirical researches of the equity premium puzzle.

The equity premium which is defined as the return on the stock less the return on the risk-free asset is an observable phenomenon in the US. Mehra and Prescott (1985) show a high equity premium in US. The degree of risk aversion necessary to explain this premium is very high compared to the experimental evidence. Thus, the equity premium puzzle has simulated an extensive research effort in behavioral finance (Han and Hsu, 2004).

Benartzi and Thaler (1995) propose an explanation of this puzzle based on two behavioral concepts: loss aversion and mental accounting. They dub this combination as Myopic Loss Aversion (MLA). Loss aversion specifies that individuals are more sensitive to losses than to gains. Mental accounting (Kahneman and Tversky, 1984; and Thaler, 1985) specifies that individuals employ implicit methods to code and evaluate financial outcomes.

Applied Finance Journal, Winter Blues, Stock Market Returns, Tunisian Stock Exchange, Trading Strategies, Stock Market Anomalies, Tunisian Stock Market, OLS Regression Method, Clinical Research, Risk Aversion.