Behavioral Finance -- Asset Prices Predictability, Equity Premium Puzzle, Volatility Puzzle: The Rational Finance Approach

📝 Abstract

In this paper we address three main objections of behavioral finance to the theory of rational finance, considered as anomalies the theory of rational finance cannot explain: Predictability of asset returns, The Equity Premium, (The Volatility Puzzle. We offer resolutions of those objections within the rational finance. We do not claim that those are the only possible explanations of the anomalies, but offer statistical models within the rational theory of finance which can be used without relying on behavioral finance assumptions when searching for explanations of those anomalies.

💡 Analysis

In this paper we address three main objections of behavioral finance to the theory of rational finance, considered as anomalies the theory of rational finance cannot explain: Predictability of asset returns, The Equity Premium, (The Volatility Puzzle. We offer resolutions of those objections within the rational finance. We do not claim that those are the only possible explanations of the anomalies, but offer statistical models within the rational theory of finance which can be used without relying on behavioral finance assumptions when searching for explanations of those anomalies.

📄 Content

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Behavioral Finance – Asset Prices Predictability, Equity Premium Puzzle, Volatility Puzzle: The Rational Finance Approach

Svetlozar Rachev
Texas Tech University

Stoyan Stoyanov Stony Brook University

Stefan Mittnik Technical University, Berlin

Frank J. Fabozzi EDHEC Business School

Abootaleb Shirvani Texas Tech University

Abstract: In this paper we address three main objections of behavioral finance to the theory of rational finance, considered as “anomalies” the theory of rational finance cannot explain: (i) Predictability of asset returns; (ii) The Equity Premium; (iii) The Volatility Puzzle. We offer resolutions of those objections within the rational finance. We do not claim that those are the only possible explanations of the “anomalies”, but offer statistical models within the rational theory of finance which can be used without relying on behavioral finance assumptions when searching for explanations of those “anomalies”. 1.Introduction In1995, economist Werner De Bondt wrote,” The sad truth is that modern finance theory offers only a set of asset pricing models for which little support exists and a set of empirical facts for which no theory exists”. (p. 8). Even economist, Nobel Laureate, and standard finance pioneer Merton Miller admitted, in an April, 23, 1994, interview with the Economist that conventional economics had failed to explain how asset prices are set. He added, however, that he believed the new mix of psychology and finance would lead nowhere.
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Richard Zechhauser (1998) (p. 436) wrote: “I do not think that the conflict between rationalists and behavioralists will be resolved in an intellectual generation, or even 3 such generations. There are simply too many battlefields. Each side can select the ones most favorable to its own cause. From time to time there will be mutually agreed-on skirmishes. Major recent ones have centered on macroeconomics, where the evidence remains exceedingly controversial and inclusive, and finance, where markets work exceedingly well but not perfectly-an outcome, I suspect, the behavioralists will continue mounting experiments or micro evidence of non-rational chooses, for there are infinite number to be found. The rationalists will take succor from the overwhelmingly power of their model, which had a lot to do with its success in the first place, and the absence of any equivalently power competitor. Should behavior in certain salient areas be found to violate the rationality, it will be treated as beyond economics. Decisions on religion and, conceivably, on family choices or personal habits thus may command the rationalists’ attention, if they behave well: otherwise, they may be classified in the same category as the source of preferences or values, something about which we have little to add as economics.” Statman (2014) asserted: “Behavioral finance is under construction as a solid structure of finance. It incorporates parts of standard finance, replaces others, and includes bridges between theory, evidence, and practice.” Behavioral finance substitutes normal people for the rational people in standard finance. It substitutes behavioral portfolio theory for mean-variance portfolio theory, and behavioral asset pricing model for the CAPM and other models where expected returns are determined only by risk. Behavioral finance also distinguishes rational markets from hard-to- beat markets in the discussion of efficient markets, a distinction that is often blurred in standard finance, and it examines why so many investors believe that it is easy to beat the market. Moreover, behavioral finance expands the domain of finance beyond portfolios, asset pricing, and market Page | 3

efficiency and is set to continue that expansion while adhering to the scientific rigor introduced by standard finance.” Our strong option is that there is no scientific claim in the theory of behavioral finance, that could not be explained in a rational finance framework. In this paper we a address the three main objections of behavioral finance proponents against the rational finance. (𝑖) Predictability of asset returns; (𝑖𝑖)The Equity Premium; (𝑖𝑖𝑖) The Volatility Puzzle.1

1 See for example Barberis and Thales (2003) who wrote: “Behavioral finance is a new approach to financial markets that has emerged, at least in part, in response to the difficulties faced by the traditional paradigm. In broad terms, it argues that some financial phenomena can be better understood using models in which some agents are not fully rational. More specifically, it analyzes what happens when we relax one, or both, of the two tenets that underlie individual rationality…. 4. Application: The aggregate stock market Researchers studying the aggregate U.S. stock market have identified a number of interesting facts about its behavior. Three of the mo

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