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Prospect theory and stock returns: A seven factor pricing model

Author

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  • Gregoriou, Andros
  • Healy, Jerome V.
  • Le, Huong

Abstract

The single-factor Capital Asset Pricing Model (CAPM), and its multi-factor extensions, are models that seek to explain investor's expectations for returns on risky assets. Empirical studies however, show that these factor models do not fully explain variations in expected returns. We show that a simple two factor model, based on the Peak-end rule (Fredrickson & Kahneman, 1993) from Prospect Theory (Kahneman & Tversky, 1979, 1992) explains variations in asset returns more thoroughly than the CAPM or it's extensions. Our results are derived from an extensive study on all US listed securities over the time period of 1927–2014. Based on our findings, we propose a Seven-Factor asset pricing model merging the insights of Expected Utility Theory, and Prospect Theory. Our new model explains variations in asset returns more comprehensively than the CAPM and its extensions including the recently established five factor CAPM by Fama and French (2015).

Suggested Citation

  • Gregoriou, Andros & Healy, Jerome V. & Le, Huong, 2019. "Prospect theory and stock returns: A seven factor pricing model," Journal of Business Research, Elsevier, vol. 101(C), pages 315-322.
    • Handle: RePEc:eee:jbrese:v:101:y:2019:i:c:p:315-322
    DOI: 10.1016/j.jbusres.2019.04.038
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    Citations

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    Cited by:

    1. Yu-Shang Kuo & Jen-Tsung Huang, 2022. "Factor-Based Investing in Market Cycles: Fama–French Five-Factor Model of Market Interest Rate and Market Sentiment," JRFM, MDPI, vol. 15(10), pages 1-24, October.
    2. Huong Le & Andros Gregoriou, 2021. "Liquidity and asset pricing: evidence from a new free-float-adjusted price impact ratio," Journal of Economic Studies, Emerald Group Publishing Limited, vol. 49(4), pages 751-771, June.
    3. Campara, Jessica & Da Costa, Newton & Matsushita, Raul & Da Silva, Sergio, 2021. "Two selves and two minds in a longitudinal survey of risk attitudes," Journal of Behavioral and Experimental Finance, Elsevier, vol. 29(C).
    4. Rizwan Ahmed & Fatima Yusuf & Maria Ishaque, 2024. "Green bonds as a bridge to the UN sustainable development goals on environment: A climate change empirical investigation," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 29(2), pages 2428-2451, April.
    5. Jiang, Ping & Wang, Xinyi & Yuan, Bozong & Zhao, Lu, 2024. "Do investors prefer multiple small bad news events or a single big one? Evidence from the Chinese stock market," Finance Research Letters, Elsevier, vol. 62(PA).
    6. Ramzi Boussaidi & Majed Ibrahim AlSaggaf, 2024. "Post-Earnings Announcement Drift, Momentum, and Contrarian Strategies in the Saudi Stock Market: Risk Explanation vs. Behavioral Explanation," Journal of the Knowledge Economy, Springer;Portland International Center for Management of Engineering and Technology (PICMET), vol. 15(3), pages 13622-13653, September.

    More about this item

    Keywords

    Prospect theory; Peak-end rule; Cognitive bias; CAPM;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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