TY - JOUR AU - Barberis,Nicholas AU - Huang,Ming AU - Santos,Tano TI - Prospect Theory and Asset Prices JF - National Bureau of Economic Research Working Paper Series VL - No. 7220 PY - 1999 Y2 - July 1999 UR - http://www.nber.org/papers/w7220 L1 - http://www.nber.org/papers/w7220.pdf N1 - Author contact info: Nicholas C. Barberis Yale School of Management 135 Prospect Street P O Box 208200 New Haven, CT 06520-8200 Tel: 203/436-0777 Fax: 203/432-6970 E-Mail: nick.barberis@yale.edu Ming Huang Johnson Graduate School of Management 319 Sage Hall Cornell University Ithaca, NY 14853 Tel: 607/255-9594 E-Mail: mh375@cornell.edu Tano Santos Graduate School of Business Columbia University 3022 Broadway, Uris Hall 414 New York, NY 10027 Tel: 212/854-0489 Fax: 212/316-9180 E-Mail: js1786@columbia.edu AB - We propose a new framework for pricing assets, derived in part from the traditional consumption-based approach, but which also incorporates two long-standing ideas in psychology: prospect theory, and evidence on how prior outcomes affect risky choice. Consistent with prospect theory, the investor in our model derives utility not only from consumption levels but also from changes in the value of his financial wealth. He is much more sensitive to reductions in wealth than to increases, the ``loss-aversion'' feature of prospect utility. Moreover consistent with experimental evidence, the utility he receives from gains and losses in wealth depends on his prior investment outcomes; prior gains cushion subsequent losses -- the so-called 'house-money' effect -- while prior losses intensify the pain of subsequent shortfalls. We study asset prices in the presence of agents with preferences of this type, and find that our model reproduces the high mean, volatility, and predictability of stock returns. The key to our results is that the agent's risk-aversion changes over time as a function of his investment performance. This makes prices much more volatile than underlying dividends and together with the investor's loss-aversion, leads to large equity premia. Our results obtain with reasonable values for all parameters. ER -