Prospect Theory and Stock Market Anomalies
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 past capital gain. We find that the model is helpful for thinking about a majority of the 22 anomalies.
The authors are grateful to John Campbell, Jonathan Ingersoll, Eben Lazarus, Ian Martin, Dimitri Vayanos, Keith Vorkink, and seminar participants at Boston College, Caltech, the London Business School, the London School of Economics, Princeton University, the University of California at Berkeley, the University of Maryland, the University of Miami, the University of Notre Dame, Washington University, Yale University, the AFA, the Miami Behavioral Finance conference, and the NBER Behavioral Finance conference for very helpful comments. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.