The Impact of Prospect Theory on Aggregate Asset Prices

What are two puzzles in aggregate asset prices that can be explained by investors with Prospect Theory preferences?

a) Equity Premium Puzzle and Excess Volatility Puzzle

Two puzzles in aggregate asset prices that can be explained if investors have Prospect Theory preferences are the equity premium puzzle and the excess volatility puzzle. In both cases, the key ingredient of Prospect Theory that helps explain these puzzles is that investors value gains and losses differently, placing more weight on perceived gains versus perceived losses.

What is the value effect in asset prices? What efficient markets hypothesis does this violate and what are some caveats?

b) The Value Effect and Efficient Markets Hypothesis Violation

The value effect refers to the tendency of stocks with lower price-to-book ratios to have higher average returns than stocks with higher price-to-book ratios. This violates the semi-strong form of the efficient markets hypothesis, which assumes that all publicly available information is already factored into stock prices. However, there are some caveats to this effect, such as the fact that it may not hold true in all markets or time periods.