Asset-pricing implications of biologically based non-expected utility

Results in population ecology suggest that evolutionary successful species should have an adaptive (reference-based) S-shaped utility function that is intrinsically   more sensitive to aggregate than uninsured idiosyncratic shocks—the former cannot be diversified demographically. To test the asset-pricing relevance of these ideas, I embed the non-expected utility specification implied by evolutionary theory into an economy with partial risk sharing due to limited commitment. For the benchmark specification (CRRA=6CRRA=6 over gains), Monte Carlo simulations of a Markov growth economy produce the following results: (i) matching the degree of consumption-smoothing in the cross section, the Sharpe ratio for a Lucas tree is 0.33, an increase of 44 percent relative to expected utility; (ii) the risk-free rate is low, stable and counter-cyclical, hence equity returns, unlike in the expected utility case, have the correct pattern of predictability; (iii) in the cross section, excess returns across equity classes exhibit both a value premium and a size discount with risk adjusted returns that are at least two times higher than their expected utility counterparts.

► Analyzes the asset pricing implications of biologically motivated preferences. ► Simulates the return distributions for a Lucas tree and the six Fama/French classes. ► The unconditional Sharpe ratio for the Lucas tree is 0.33. ► Simulated results match the empirical patter of excess return predictability. ► Cross-sectional equity distribution features a value premium and a size discount.