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Resource allocation in the brain and the equity premium puzzle

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  • Siddiqi, Hammad

Abstract

What happens when information reaches the human brain? In economics, a black box approach to information absorption is generally taken with an implicit assumption that, information, once it reaches the brain, is correctly processed. In sharp contrast, research in brain sciences has established that when information reaches the brain, a pre-existing knowledge structure or schema is first activated, which influences information absorption. The process through which these knowledge structures are created is resource intensive. It involves using a pre-existing schema as a starting point and attempting to adjust it appropriately by using finite brain resources. We apply this approach to the thinking process of investors trying to work out the worth of various stocks. We show that with a binding resource constraint, a new multiplicative term emerges on the right-hand-side of the standard Sharpe-ratio expression in asset pricing. This new term provides a unified explanation for the equity premium puzzle, generates counter-cyclical equity premia, and gives rise to size, value, and momentum effects. A novel prediction of the approach is negative correlation of momentum with value and size

Suggested Citation

  • Siddiqi, Hammad, 2020. "Resource allocation in the brain and the equity premium puzzle," MPRA Paper 100432, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:100432
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    References listed on IDEAS

    as
    1. Siddiqi, Hammad, 2020. "Resource allocation in the brain and the Capital Asset Pricing Model," MPRA Paper 100250, University Library of Munich, Germany.
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    More about this item

    Keywords

    Equity Premium Puzzle; Value Effect; Momentum Effect; Size Effect; Counter-cyclical Equity Premia; Schema; Resource Allocation;
    All these keywords.

    JEL classification:

    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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