When Prospect Theory Meets Mean-Reverting Asset Returns: A Behavioral Dynamic Trading Model

Jianjun Gao, Duan Li, Jinyan Xie, Yiwen Yang and Jing Yao

Journal of Banking & Finance, 2024, vol. 162, issue C

Abstract: We develop a continuous-time asset allocation model to investigate the effects of mean-reverting stock returns on investors with Prospect Theory (PT) preferences. Our semi-analytical solution facilitates a comprehensive exploration of how the stock investment of PT investors may differ when accounting for mean reversion. We find that incorporating mean reversion attenuates the distinct V-shaped demand pattern in relation to contemporaneous prices, which is more pronounced when mean reversion is absent, by significantly reducing PT investors’ stock demand following price increases. This shift leads to a stock demand profile that demonstrates an inverse relationship with stock prices. In line with this change, we also show that combining PT utility with mean reversion predicts short-term contrarian behavior and the disposition effect more reliably than benchmark models that incorporate either PT utility or mean-reverting returns alone.

Keywords: Prospect theory; Mean reversion; Dynamic asset allocation; Individual Trading Behavior (search for similar items in EconPapers)
Date: 2024
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0378426624000797
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:162:y:2024:i:c:s0378426624000797

DOI: 10.1016/j.jbankfin.2024.107159

Access Statistics for this article

Journal of Banking & Finance is currently edited by Ike Mathur

More articles in Journal of Banking & Finance from Elsevier
Bibliographic data for series maintained by Catherine Liu ().