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

TL;DR

This paper defends rational finance by providing statistical models that explain asset return predictability, the equity premium puzzle, and the volatility puzzle, addressing key objections from behavioral finance.

Contribution

It introduces models within rational finance that explain major anomalies traditionally attributed to behavioral finance, without relying on behavioral assumptions.

Findings

Models successfully explain asset return predictability

Addresses the equity premium puzzle within rational finance

Provides explanations for the volatility puzzle

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.