From boom til bust: how loss aversion affects asset prices

In 1996 Alan Greenspan warned that stock prices were "unduly escalated" and reflected "irrational exuberance". In this paper we describe an economy that can support a prolonged surge of asset prices, accompanied by a sharp increase of volatility. We study an equilibrium model where some agents are risk averse while others have loss averse preferences over wealth, according to prospect theory. We derive closed-form solutions for the equilibrium prices. In good states of the world, the loss averse investors with wealth above the threshold are momentum traders, thereby pushing prices far above the level in the benchmark economy. In moderately bad states of the world, the loss averse investors are contrarian, and equilibrium prices are kept relatively high and stable. Finally in extremely bad states, the loss averse investors are forced to retreat from the stock market in order to avoid bankruptcy, resulting in a sharp price drop.