Prospect Theory and Stock Market Anomalies

Abstract

We present a new model of asset prices in which investors evaluate risk according to prospect theory and examine its ability to explain 23 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 23 anomalies.

Keywords: prospect theory, loss aversion, probability weighting, cross-section

JEL Classification: G11, G12