Resource Allocation in the Brain and the Equity Premium Puzzle

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