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Resource allocation in the brain and the Capital Asset Pricing Model

Author

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  • Siddiqi, Hammad
Abstract
What happens when information reaches the human brain? In economics, a black-box approach to information processing in the brain is generally taken with an implicit assumption that information, once it reaches the brain, is accurately processed. In sharp contrast, research in brain sciences has established that when information reaches the brain, a mental template or schema (neural substrate of knowledge) is first activated, which influences information absorption. Schemas are created through a resource intensive process in which finite brain resources are allocated to different tasks, with resource allocation in the brain having an impact on the structure of schemas. In this article, we explore the implications of this richer view from brain sciences for the capital asset pricing model (CAPM). We show that two versions of CAPM arise depending on how the brain resources are allocated in schema creation. In one version, the relationship between beta and expected returns is flat along with value and size effects. In the second version, the relationship between beta and expected return is strongly positive with an implied risk-free rate which could be negative. The two version CAPM provides a unified explanation for a series of empirical findings including high-alpha-of-low-beta, size and value effect as well as strongly positive relationship between beta and average stock returns at specific times such as on macroeconomic announcement days, and at market open. As certain morbidities, such as autism, are thought to be associated with lack of schemas that attenuate information, a laboratory experiment with high functioning autism sufferers might be our best bet at observing the classical CAPM in its full glory.

Suggested Citation

  • Siddiqi, Hammad, 2020. "Resource allocation in the brain and the Capital Asset Pricing Model," MPRA Paper 100250, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:100250
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    File URL: https://mpra.ub.uni-muenchen.de/100521/10/MPRA_paper_100521.pdf
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    References listed on IDEAS

    as
    1. Ricardo Alonso & Isabelle Brocas & Juan D. Carrillo, 2014. "Resource Allocation in the Brain," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 81(2), pages 501-534.
    2. Sudipta Basu & Truong Xuan Duong & Stanimir Markov & Eng-Joo Tan, 2013. "How Important are Earnings Announcements as an Information Source?," European Accounting Review, Taylor & Francis Journals, vol. 22(2), pages 221-256, June.
    3. Frazzini, Andrea & Pedersen, Lasse Heje, 2014. "Betting against beta," Journal of Financial Economics, Elsevier, vol. 111(1), pages 1-25.
    4. Graham, John R. & Harvey, Campbell R. & Rajgopal, Shiva, 2005. "The economic implications of corporate financial reporting," Journal of Accounting and Economics, Elsevier, vol. 40(1-3), pages 3-73, December.
    5. Randolph B. Cohen & Christopher Polk & Tuomo Vuolteenaho, 2005. "Money Illusion in the Stock Market: The Modigliani-Cohn Hypothesis," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 120(2), pages 639-668.
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    Cited by:

    1. Siddiqi, Hammad, 2020. "Resource allocation in the brain and the equity premium puzzle," MPRA Paper 100432, University Library of Munich, Germany.

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    More about this item

    Keywords

    CAPM; Value Premium; Size Effect; Schema Theory; Low Beta Anomaly;
    All these keywords.

    JEL classification:

    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G1 - Financial Economics - - General Financial Markets
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G19 - Financial Economics - - General Financial Markets - - - Other

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