Prospect Theory and Asset Prices

TLDR

The model assumes investors derive utility from consumption and wealth changes, with loss‑aversion making them more sensitive to wealth reductions than gains, consistent with prospect theory. The study proposes a new asset‑pricing framework that blends consumption‑based theory with prospect theory and the house‑money effect. The model prices assets by combining consumption‑based utility with prospect‑theory loss aversion and a house‑money effect where prior gains dampen, and prior losses amplify, subsequent wealth changes. The model reproduces the high mean, volatility, and predictability of stock returns, showing that time‑varying risk aversion driven by investment performance, combined with loss aversion, generates volatility beyond dividends and yields large equity premia, all with realistic parameter values.

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: the prospect theory of Kahneman and Tversky (1979), and the evidence of Thaler and Johnson (1990) and others on the influence of prior outcomes on 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 restuls 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.