Informative Starting Points and Asset-Return Puzzles
37 Pages Posted: 24 Feb 2017 Last revised: 9 Apr 2017
Date Written: March 1, 2017
In estimation tasks, decision-makers typically use introspection to arrive at an informative starting point. The starting point is understood to be somewhat incorrect and attempts are made to make appropriate adjustments. A robust finding from psychology and economics literature is that such adjustments tend to be insufficient leaving the final answer biased towards the starting value. Given the ubiquity and usefulness of starting points, it is no surprise that professional equity-analysts co-categorize closely-related firms in peer-groups and routinely use the analysis of a prominent firm as an informative starting point for other firms in the same peer-group. However, surprisingly, I find that the implications of introducing this common-sense innovation in the standard consumption-based model are quite startling. A unified explanation for prominent puzzles emerges. The puzzles potentially resolved are: high equity-premium, counter-cyclical premiums, size effect, value effect, and media-coverage effect. The adjusted-model makes a novel prediction: In a peer-group, stocks with less volatile payoffs have higher Sharpe-ratios than stocks with more volatile payoffs. Empirical evidence consistent with this prediction is presented.
Keywords: High Equity Premium, Countercyclical Premium, Size Premium, Value Effect, Low Volatility Anomaly, Media Coverage Effect
JEL Classification: G12, G10, G02
Suggested Citation: Suggested Citation