Prospect Theory and Stock Returns: An Empirical Test

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