The Equity Premium Puzzle

Why are investors so afraid of risk?  Sure, it's possible to lose your shirt (and a posterior portion of your anatomy) in the stock market, but don't the rewards outweigh the danger?

A famous economic study on the equity premium puzzle showed that stocks outperform bonds by so much (on average 6% per year) that you would think that investors would choose more stocks than they do.  To quote Wikipedia's version of the common (and ludicrously conservative) tendency, "To quantify the level of risk aversion implied, investors would have to be indifferent between a bet with a 50 percent chance of $50,000 or $100,000 and a certain payoff of $51,209." 

Why are people so averse to taking small risks that they would do the equivalent of "cashing out" for $1,209 over their WORST possible outcome, forgoing a 50% chance of winning $50K?  And (putting on my Applied Evil Genius hat) how can we turn other people's risk extreme aversion to our own advantage? 

Comments

[Robert Speirs]

$50,000 is the "worst possible outcome" in the stock market? Nassim Taleb's book "Fooled by Randomness" has encouraged me to look on such claims with some skepticism. Why isn't it possible to lose all your money? At least with government bonds that's unlikely, but still not impossible.

Mycroft:
But imagine starting off with $51,209. You invest $50K of your money in something extremely safe (like a money-market fund) and have the option of taking a wild fling with the other $1,209. In particular, you can flip a coin; if you win, you gain $48,791 and if you lose, you still have your $50K nest egg. The average investor hems and haws over this choice and has no clear preference for the coin flip. I mean, c'mon. If one stood to lose $10K, $20K, or maybe even $5K I could see some justification for this level of conservatism -- but getting 40-1 odds on a coin flip for 2.4% of your money, and not grabbing it before the sucker offering it changes his mind, smacks of either very bad math or a serious psychological pathology!