Abstract
Standard asset pricing models with rational expectations struggle to jointly account for three prominent features of aggregate stock returns: a large equity premium, excess volatility, and the asymmetric volatility phenomenon (AVP), whereby volatility rises more after negative return shocks than after positive shocks of the same magnitude. I develop a consumption-based asset pricing model in which investors are loss averse and form diagnostic expectations. These two complementary mechanisms generate high and volatile discount rates that respond asymmetrically to news. With empirically plausible degrees of loss aversion and diagnosticity, the model jointly accounts for the equity premium, excess volatility, volatility clustering, and the AVP. These results show that a unified behavioral framework can jointly account for several central features of aggregate asset prices through endogenous mechanisms.