Log, Stock and Two Simple Lotteries

Abstract

This paper studies the problem of decision-making under risk by agents whose information processing abilities may be limited. The constructed theoretical framework grounds on findings of economic laboratory experiments, incorporates existing neuroscience knowledge, and is implemented using information-theoretic formalism. Activation of the above information-processing constraints distorts the subjective perception of objective stochastic environment the agent operates in, and constrained-optimal decision-making requires appropriate adjustments. In the selected application, a general equilibrium macro-finance model, such biases of subjective perspective as overconfidence, pessimism and categorization thus emerge endogenously. The theoretical implications receive solid empirical support: according to (cross-checked) calibrations, they allow to rationalize the phenomena known as equity premium/risk-free rate puzzles; as well as contribute to the understanding of such regularities as portfolio underdiversification puzzle, style investing and non-monotone pricing kernel puzzle. On the other hand, these results also help rationalize, by formulating certain optimizing foundations behind, the (cumulative) prospect theory and experimental evidence it systematizes.