Prospect Theory and Stock Market Anomalies
64 Pages Posted: 8 Nov 2019 Last revised: 6 May 2020
Date Written: May 5, 2020
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 volatility, skewness, and capital gain overhang. We find that the model is helpful for thinking about a majority of the 22 anomalies.
Keywords: prospect theory, loss aversion, probability weighting, cross-section
JEL Classification: G11, G12
Suggested Citation: Suggested Citation