When Prospect Theory Meets Mean-Reverting Asset Returns: A Behavioral Dynamic Trading Model

36 Pages Posted: 30 Apr 2018 Last revised: 17 Apr 2023

See all articles by Jianjun Gao

Jianjun Gao

Shanghai Jiao Tong University; Shanghai University of Finance and Economics

Duan Li

Chinese University of Hong Kong; City University of Hong Kong

Jinyan Xie

Shanghai University of Finance and Economics

Yiwen Yang

Fudan University

Jing Yao

School of Economics, Fudan University

Date Written: September 1, 2022

Abstract

We develop a continuous-time asset allocation model to analyze the implications of mean reversion in stock returns for investors with prospect theory preferences and obtain a semi-analytical solution of the model. Numerical results based on this solution show that for prospect-theory investors, higher state price density tends to increase investor stock demand (at a decreasing rate) in the presence of mean reversion, although the demand is typically V-shaped with respect to state price density in the absence of mean reversion. Consistent with this change,
we further show that the combination of prospect theory preferences and mean reversion predicts contrarian trading behavior and the disposition effect more reliably than the benchmark models that introduce either prospect theory preferences or mean-reverting returns alone.

Keywords: Prospect Theory, Mean Reversion, Dynamic Asset Allocation, Trading Behavior, Disposition Effect

JEL Classification: G11, C61

Suggested Citation

Gao, Jianjun and Li, Duan and Li, Duan and Xie, Jinyan and Yang, Yiwen and Yao, Jing, When Prospect Theory Meets Mean-Reverting Asset Returns: A Behavioral Dynamic Trading Model (September 1, 2022). Available at SSRN: https://ssrn.com/abstract=3161166 or http://dx.doi.org/10.2139/ssrn.3161166

Jianjun Gao (Contact Author)

Shanghai Jiao Tong University ( email )

800 Dongchuan Road
Shanghai
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+86-18201925139 (Phone)
+86 34205004 (Fax)

Shanghai University of Finance and Economics ( email )

No. 100 Wudong Road
Shanghai, Shanghai 200433
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Duan Li

Chinese University of Hong Kong ( email )

Shatin, New Territories
Hong Kong

City University of Hong Kong

Tat Chee Avenue
Kowloon Tong
Kowloon
Hong Kong
852 3442 8591 (Phone)

Jinyan Xie

Shanghai University of Finance and Economics ( email )

NO. 777 Guoding Road
Shanghai, 200433
China

Yiwen Yang

Fudan University ( email )

600 GuoQuan Road
Shanghai, 200433
China

Jing Yao

School of Economics, Fudan University ( email )

600 Guoquan Road
Shanghai, Shanghai 200433
China

HOME PAGE: http://homepage.fudan.edu.cn/yaojing/

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