Anchoring and Adjustment Heuristic: A Unified Explanation for Asset-Return Puzzles

Abstract

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. We introduce the following innovation in the standard consumption-based assetpricing model: The representative-agent behaves like a professional equity-analyst. The surprising finding is that a unified explanation for prominent asset-return puzzles emerges. The puzzles addressed are: high equity-premium, counter-cyclical premiums, size effect, value effect, and mediacoverage effect. The adjusted model makes a novel prediction: stocks with less volatile payoffs have higher Sharpe-ratios than stocks with more volatile payoffs. Empirical evidence supports this prediction.JEL Classification: G10, G12, G02