Prospect Theory and Asset Prices

Nicholas Barberis, Ming Huang and Tano Santos

No 7220, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: G12 (search for similar items in EconPapers)
Date: 1999-07
New Economics Papers: this item is included in nep-fin
Note: AP
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (26)

Published as Barberis, Nicholas, Ming Huang and Tano Santos. "Prospect Theory And Asset Prices," Quarterly Journal of Economics, 2001, v116(1,Feb), 1-53.

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