Fuzzy decision-making in asset markets

Abstract This paper develops an infinite-horizon, Lucas-type general equilibrium model of asset markets with a fuzzy decision-making investor. The model yields closed-form intuitive solutions for the equilibrium equity premium and risk-free rate. The solutions clearly separate the equity premium that investors demand for bearing measurable risk from the premium that arises from unmeasurable uncertainty. The magnitude of the premium for risk depends solely on risk aversion, whereas the premium for unmeasurable uncertainty reflects both investor sentiment and the degree of that uncertainty. Our results imply that a pessimistic outlook reduces the risk-free rate and increases the equity premium. Under reasonable parameterizations, the model generates the long-run first moments of the U.S. risk-free rate and equity premium with moderate risk aversion and without inflating the variance of equity returns. This work contributes to the asset-pricing literature by showing that fuzzy sets and membership functions provide a tractable and flexible framework for modeling approximate decision-making in asset markets.