Anchoring and Adjustment Heuristic: A Unified Explanation for Asset-Return Puzzles
26 Pages Posted: 11 Jan 2016 Last revised: 25 Feb 2017
Date Written: October 1, 2016
Decision-makers typically rely on informative starting points that are somewhat incorrect and then attempt to make appropriate adjustments. Such reliance on informative starting points may be an optimal response of a Bayesian decision-maker who faces finite computational resources (Lieder et al 2013). Professional equity-analysts take the same approach when they co-categorize closely related firms in peer-groups and routinely extrapolate the analysis pertaining to a prominent firm to other firms in the same peer-group. We show that if the representative agent behaves like a professional equity analyst, then a unified explanation for 5 asset-market phenomena emerges. The phenomena explained include high and counter-cyclical equity premium, size effect, value premium, and media-coverage effect. A novel prediction of the model is that stocks with less volatile payoffs outperform stocks with more volatile payoffs. Empirical evidence strongly supports this prediction.
Keywords: The Equity Premium Puzzle, Anchoring Bias, The Risk-Free Rate Puzzle, Countercyclical Equity Premium, Stock Price Volatility, Knightian Uncertainty
JEL Classification: G02, G11, G12, D80, D81
Suggested Citation: Suggested Citation