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Prospect Theory and Asset Prices

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  • Nicholas Barberis
  • Ming Huang
  • Tano Santos
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    Abstract

    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.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7220.

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    Date of creation: Jul 1999
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    Publication status: published as Barberis, Nicholas, Ming Huang and Tano Santos. "Prospect Theory And Asset Prices," Quarterly Journal of Economics, 2001, v116(1,Feb), 1-53.
    Handle: RePEc:nbr:nberwo:7220

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    Cited by:
    1. Patricia Tovar, 2004. "The Effects of Loss Aversion on Trade Policy and the Anti-Trade Bias Puzzle," Econometric Society 2004 North American Summer Meetings 499, Econometric Society.
    2. Andrew Ang & Geert Bekaert & Jun Liu, 2000. "Why Stocks May Disappoint," NBER Working Papers 7783, National Bureau of Economic Research, Inc.
    3. Levy, Haim & Levy, Moshe, 2002. "Experimental test of the prospect theory value function: A stochastic dominance approach," Organizational Behavior and Human Decision Processes, Elsevier, vol. 89(2), pages 1058-1081, November.
    4. Matthew C. Li, 2003. "Wealth, Volume and Stock Market Volatility: Case of Hong Kong (1993-2001)," Trinity Economics Papers 20035, Trinity College Dublin, Department of Economics.
    5. Aaron Tornell, 2000. "Robust-H-infinity Forecasting and Asset Pricing Anomalies," NBER Working Papers 7753, National Bureau of Economic Research, Inc.
    6. Matthew Rabin., 2000. "Inference by Believers in the Law of Small Numbers," Economics Working Papers E00-282, University of California at Berkeley.
    7. John Heaton & Deborah Lucas, 2000. "Stock prices and fundamentals," Proceedings, Federal Reserve Bank of San Francisco, issue Apr.
    8. Aaron Tornell, 2003. "Robust-H_infinity Forecasting and Asset Pricing Anomalies (December 2001)," UCLA Economics Online Papers 237, UCLA Department of Economics.
    9. Zin, Stanley E., 2002. "Are behavioral asset-pricing models structural?," Journal of Monetary Economics, Elsevier, vol. 49(1), pages 215-228, January.
    10. Tan Wang, 2000. "Updating Rules for Non-Bayesian Preferences," Econometric Society World Congress 2000 Contributed Papers 0157, Econometric Society.

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