Prospect Theory and Asset Prices

50 Pages Posted: 30 Apr 2000 Last revised: 13 Oct 2010

See all articles by Nicholas Barberis

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: July 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: prospect theory, and evidence on how prior outcomes affect 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 results 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.

Suggested Citation

Barberis, Nicholas and Huang, Ming and Santos, Tano, Prospect Theory and Asset Prices (July 1999). NBER Working Paper No. w7220. Available at SSRN: https://ssrn.com/abstract=214388

Nicholas Barberis (Contact Author)

Yale School of Management ( email )

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Ming Huang

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

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Tano Santos

Columbia Business School ( email )

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United States
212-854-0489 (Phone)
212-316-9180 (Fax)

National Bureau of Economic Research (NBER)

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United States

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