Prospect Theory and Stock Market Anomalies
61 Pages Posted: 8 Nov 2019
Date Written: October 29, 2019
We present a new model of asset prices in which investors evaluate risk according to prospect theory and examine its ability to explain 22 prominent stock market anomalies. The model incorporates all the elements of prospect theory, takes account of investors' prior gains and losses, and makes quantitative predictions about an asset's average return based on empirical estimates of its beta, volatility, skewness, and capital gain overhang. We find that the model is helpful for thinking about a majority of the anomalies we consider. It performs particularly well for the momentum, volatility, distress, and profitability anomalies, but poorly for the value anomaly. For several anomalies, the model explains not only the average returns of extreme anomaly deciles, but also more granular patterns in the average returns of intermediate deciles.
Keywords: prospect theory, loss aversion, probability weighting, cross-section
JEL Classification: G11, G12
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