can someone please explain why mental accounting had caused high histoical equity premium relative to the underlying fundamentals?
You are right that in the reading this relation is not explained and in summary this has suddenly popped out… Let me try to put down as I understand it: In the past, Investors kept Equity investments in a different mental account (separate from the Bond investments)… and therefore asked for ‘x’ amount of equity premium However, if bond and equity investments are viewed as one, it would provide diversification benefits and therefore reduce the risk and also the equity risk premium assume ‘y’. statistically, ‘x’ has been more than ‘y’. and it can be attributed to Mental Accounting bias.
my understanding: mental accounting doesn’t considers correlation among various asset classes which tends to be <1. Therefore perception of higher risk and resultant requirement of higher returns / equity risk premium