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Prospect Theory and Asset Prices

50 Pages Posted: 22 Jul 1999  

Nicholas Barberis

Yale School of Management; National Bureau of Economic Research (NBER)

Ming Huang

Cornell University - Samuel Curtis Johnson Graduate School of Management

Tano Santos

Columbia Business School; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: June 1999

Abstract

We propose a new framework for pricing assets, derived in part from the traditional consumption-based approach, but which also incorporates two long-standing ideas in psychology: the prospect theory of Kahneman and Tversky (1979), and the evidence of Thaler and Johnson (1990) and others on the influence of prior outcomes on risky choice. Consistent with prospect theory, the investor in our model derives utility not only from consumption levels but also from changes in the value of his financial wealth. He is much more sensitive to reductions in wealth than to increases, the "loss-aversion" feature of prospect utility. Moreover, consistent with experimental evidence, the utility he receives from gains and losses in wealth depends on his prior investment outcomes; prior gains cushion subsequent losses -- the so-called "house-money" effect -- while prior losses intensify the pain of subsequent shortfalls. We study asset prices in the presence of agents with preferences of this type and find that our model reproduces the high mean, volatility, and predictability of stock returns. The key to our restuls is that the agent's risk-aversion changes over time as a function of his investment performance. This makes prices much more volatile than underlying dividends, and together with the investor's loss-aversion, leads to large equity premia. Our results obtain with reasonable values for all parameters.

JEL Classification: G12

Suggested Citation

Barberis, Nicholas and Huang, Ming and Santos, Tano, Prospect Theory and Asset Prices (June 1999). Center for Research in Security Prices (CRSP) Working Paper No. 494. Available at SSRN: https://ssrn.com/abstract=169790 or http://dx.doi.org/10.2139/ssrn.169790

Nicholas Barberis (Contact Author)

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
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National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Ming Huang

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Ithaca, NY 14853
United States
607-225-9594 (Phone)

Tano Santos

Columbia Business School ( email )

3022 Broadway - Uris Hall
Room 815
New York, NY 10027
United States
212-854-0489 (Phone)
212-316-9180 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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