Prospect Theory and Stock Returns: An Empirical Test

Barberis, Nicholas; Mukherjee, Abhiroop; Wang, Baolian

doi:10.2139/ssrn.2528149

Cited by 17 publications

(61 citation statements)

References 39 publications

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“…We also performed analogous calculations using the estimated value of the curvature parameter obtained from the certainty equivalent tasks,

γ = 0.715

, along with the associated estimate of α . These calculations are of interest because economists routinely adopt these types of CPT calibrations for the purpose of studying applied problems; prominent examples using the probability weighting parameters derived from the binary lotteries in Tversky and Kahneman () include Benartzi and Thaler (), Barberis and Huang (), and Barberis, Mukherjee, and Wang (). Such work proceeds from the assumption that valuations of binary lotteries reveal the values of “deep” CPT preference parameters that are stable across a wide range of contexts.…”

Section: Resultsmentioning

confidence: 99%

“…This alternative framing delivers the desired prediction because it alters the rankings of the four outcomes. Barberis, Mukherjee, and Wang () examined historical monthly returns at the stock level for a five‐year window and linked the CPT value of the stock's history to future returns, demonstrating a significant negative correlation. The interpretation for the negative relation is that investors overvalue positively skewed, lottery‐like stocks.…”

mentioning

confidence: 99%

“…CPT, on the other hand, allows the highest ranked outcomes to receive higher proportionate weight. Barberis, Mukherjee, and Wang () showed that CPT substantially outperforms EU in predicting future returns. Given that the PT formulation (ignoring the reference point) would be collinear with the EU formulation, rank dependence would seem critical for delivering this result.…”

mentioning

confidence: 99%

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On the Empirical Validity of Cumulative Prospect Theory: Experimental Evidence of Rank‐Independent Probability Weighting

Bernheim

Sprenger

2020

ECTA

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Cumulative Prospect Theory (CPT), the leading behavioral account of decisionmaking under uncertainty, avoids the dominance violations implicit in Prospect Theory (PT) by assuming that the probability weight applied to a given outcome depends on its ranking. We devise a simple and direct nonparametric method for measuring the change in relative probability weights resulting from a change in payoff ranks. We find no evidence that these weights are even modestly sensitive to ranks. Conventional calibrations of CPT preferences imply that the percentage change in probability weights should be an order of magnitude larger than we observe. It follows either that probability weighting is not rank‐dependent, or that the weighting function is nearly linear. Nonparametric measurement of the change in relative probability weights resulting from changes in probabilities rules out the second possibility. Additional tests nevertheless indicate that the dominance patterns predicted by PT do not arise. We reconcile these findings by positing a form of complexity aversion that generalizes the well‐known certainty effect.

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“…We also performed analogous calculations using the estimated value of the curvature parameter obtained from the certainty equivalent tasks,

γ = 0.715

Section: Resultsmentioning

confidence: 99%

mentioning

confidence: 99%

mentioning

confidence: 99%

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On the Empirical Validity of Cumulative Prospect Theory: Experimental Evidence of Rank‐Independent Probability Weighting

Bernheim

Sprenger

2020

ECTA

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“…In empirical asset pricing, it is commonly argued that systematic behavior at the individual level affects prices due to limits of arbitrage. For example, Barberis, Mukherjee, and Wang (2016) argue that the attractiveness of individual stocks' past returns under cumulative prospect theory should lead to overweighting of such stocks by individual investors, and thus, predict higher prices and lower returns. An advantage of such tests based on historical data motivated by well‐identified experimental results is additional external and ecological validity.…”

Section: From the Laboratory To Reality: The Perception Of Dependencementioning

confidence: 99%

The Perception of Dependence, Investment Decisions, and Stock Prices

Ungeheuer¹,

Weber²

2020

The Journal of Finance

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How do investors perceive dependence between stock returns; and how does their perception of dependence affect investments and stock prices? We show experimentally that investors understand differences in dependence, but not in terms of correlation. Participants invest as if applying a simple counting heuristic for the frequency of comovement. They diversify more when the frequency of comovement is lower even if correlation is higher due to dependence in the tails. Building on our experimental findings, we empirically analyze U.S. stock returns. We identify a robust return premium for stocks with high frequencies of comovement with the market return.

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“…Henderson (2012), Barberis and Xiong (2009), and Hensand Vlcek (2011) demonstrated that investors are risk-averse after trading for a gain, but more cautious after trading for a loss, after which they tend to hold on to stocks whose prices have dropped. More recently, Barberis et al (2016) showed that when investors make a decision to buy or sell equities, they initially represent them by the distribution of their past returns and then evaluate them using the prospect theory. Thus, based on the foregoing discussion, we assumed that a d v ' k l xpl g v l p between VOL and future stock returns.…”

Section: Literature Reviewmentioning

confidence: 99%

Asymmetric Reaction of Investors to Market Risk, Illiquidity Risk, and Credit Risk: Evidence from Tehran Stock Exchange (TSE)

Peymany

Erza

Seifi

2020

IJFIFSA

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The relationship between risk and return is not symmetric under different circumstances. As the prospect theory describes, the value function which passes through the reference point is steeper for losses than gains (asymmetric risk appetite). But such an asymmetrical risk aversion could be traced in different periods of investment and market boom and bust cycles behind the reference point. Moreover, v ' ic behavior is different regarding various risks, such as market risk, illiquidity risk, and credit risk. This paper examines the asymmetric investors' reaction to various risks in Tehran Stock Exchange (TSE) both in recession and growth from 2011 through 2016. Evidence reveals that although all three kinds of k l v , p ll ll q d k, k ' xpl p w bullish market is less than the bearish one. This indicates that investors tend to show an asymmetric reaction to risk in up and downswing markets. The asymmetric b v l p d d v ' w k k k growing market in opposition to a recessive market condition that turns out to be an important risk consideration. The results of this study can help investors to consider asymmetrical behavior effect when they are making their minds on investment decisions.

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Prospect Theory and Stock Returns: An Empirical Test

Cited by 17 publications

References 39 publications

On the Empirical Validity of Cumulative Prospect Theory: Experimental Evidence of Rank‐Independent Probability Weighting

On the Empirical Validity of Cumulative Prospect Theory: Experimental Evidence of Rank‐Independent Probability Weighting

The Perception of Dependence, Investment Decisions, and Stock Prices

Asymmetric Reaction of Investors to Market Risk, Illiquidity Risk, and Credit Risk: Evidence from Tehran Stock Exchange (TSE)

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