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Prospect Theory and Stock Returns: An Empirical Test

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  • Nicholas Barberis
  • Abhiroop Mukherjee
  • Baolian Wang

Abstract

We test the hypothesis that, when thinking about allocating money to a stock, investors mentally represent the stock by the distribution of its past returns and then evaluate this distribution in the way described by prospect theory. In a simple model of asset prices in which some investors think in this way, a stock whose past return distribution has a high (low) prospect theory value earns a low (high) subsequent return, on average. We find empirical support for this prediction in the cross-section of stock returns in the U.S. market, and also in a majority of forty-six other national stock markets. (JEL D03)Received November 19, 2014; accepted May 20, 2016, by Editor Stefan Nagel.

Suggested Citation

  • Nicholas Barberis & Abhiroop Mukherjee & Baolian Wang, 2016. "Prospect Theory and Stock Returns: An Empirical Test," The Review of Financial Studies, Society for Financial Studies, vol. 29(11), pages 3068-3107.
    • Handle: RePEc:oup:rfinst:v:29:y:2016:i:11:p:3068-3107.
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    JEL classification:

    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles

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