Applications of Regret Theory to Asset Pricing

Abstract

This paper presents a theoretical model of asset pricing that analyses how the behavior of stock returns is affected by the presence of regret-averse investors on the market. The model helps to explain the excess volatility and autocorrelation of stock returns. In addition, the model predicts a positive correlation between future trading volume and the dispersion of the realized stock returns and helps to analyze how an improvement of stock market accessibility for non-professional traders affects the predictability of stock returns. Using recent stock market data the second part of the paper provides an empirical analysis of some of the model's implications.

Keywords: Regret Theory, Asset Pricing, Behavioral Finance

JEL Classification: G12, G19