Asset Pricing in the Resource-Constrained Brain

Despite scarcity being central to economics, the scarcity of brain’s internal resources has largely been ignored. Neuroscience research increasingly points to the brain evolving as a prediction engine in response to this internal-resource scarcity. The brain meets every situation with subconscious expectations, which are contrasted with information to generate error-signals. Selective processing of such error-signals, in lieu of the entire information-stream, saves brain-resources. We show that applying this predictive-processing framework to asset pricing gives rise to an alpha in CAPM. Several empirically observed phenomena (value, momentum, size, high-alpha-of-low-beta, profitability, investment, and time-specific changes in SML slopes) correspond to either cross-sectional or time-specific variations in this alpha. Additional insights about these phenomena emerge that are consistent with empirical evidence. Hence, potentially, a unified explanation for several asset pricing anomalies emerges as ultimately due to the brain’s optimal response to its own internal resource scarcity, suggesting a synthesis of neoclassical and behavioral finance.