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Resource allocation in the brain and the Capital Asset Pricing Model

Siddiqi, Hammad (2020): Resource allocation in the brain and the Capital Asset Pricing Model.

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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.

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