Prospect Theory and Stock Returns: An Empirical Test

Review of Financial Studies, Forthcoming

AFA 2014 Philadelphia Meetings Paper

56 Pages Posted: 20 Nov 2014 Last revised: 5 Oct 2016

See all articles by Nicholas Barberis

Nicholas Barberis

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

Abhiroop Mukherjee

Hong Kong University of Science & Technology (HKUST) - Department of Finance

Baolian Wang

University of Florida - Department of Finance, Insurance and Real Estate

Date Written: February 8, 2016

Abstract

We test the hypothesis that, when thinking about allocating money to a stock, investors mentally represent the stock by the distribution of its past returns and then evaluate this distribution in the way described by prospect theory. In a simple model of asset prices where some investors think in this way, a stock whose past return distribution has a high (low) prospect theory value earns a low (high) subsequent return, on average. We find empirical support for this prediction in the cross-section of U.S. stock returns, particularly among small-capitalization stocks where less sophisticated investors are likely to have a bigger impact on prices. We repeat our tests in 46 international stock markets and find a similar pattern in a majority of these markets.

Keywords: prospect theory, loss aversion, probability weighting

JEL Classification: D03

Suggested Citation

Barberis, Nicholas and Mukherjee, Abhiroop and Wang, Baolian, Prospect Theory and Stock Returns: An Empirical Test (February 8, 2016). AFA 2014 Philadelphia Meetings Paper . Available at SSRN: https://ssrn.com/abstract=2528149 or http://dx.doi.org/10.2139/ssrn.2528149

Nicholas Barberis (Contact Author)

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-436-0777 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Abhiroop Mukherjee

Hong Kong University of Science & Technology (HKUST) - Department of Finance ( email )

Clear Water Bay, Kowloon
Hong Kong

Baolian Wang

University of Florida - Department of Finance, Insurance and Real Estate ( email )

314 Stuzin Hall
Gainesville, FL 32611
United States

HOME PAGE: http://www.wangbaolian.com

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