Prospect theory

A loyal MR reader asks about prospect theory.  I feel it is usually too experimental and too ad hoc, are those really the general biases out there in markets?  I was heartened to see the following good paper (non-gated here) on prospect theory and the stock market.  The abstract:

We study the asset pricing implications of Tversky and Kahneman’s
(1992) cumulative prospect theory, with particular focus on its
probability weighting component.  Our main result, derived from a novel
equilibrium with non-unique global optima, is that, in contrast to the
prediction of a standard expected utility model, a security’s own
skewness can be priced: a positively skewed security can be
"overpriced," and can earn a negative average excess return.  Our
results offer a unifying way of thinking about a number of seemingly
unrelated financial phenomena, such as the low average return on IPOs,
private equity, and distressed stocks; the diversification discount;
the low valuation of certain equity stubs; the pricing of
out-of-the-money options; and the lack of diversification in many
household portfolios.

In other words, we can think of stocks as a lottery ticket.  They offer a chance at the thrill of victory, and not just a mean-variance pair; this may help explain various pricing and return anomalies.  Am I convinced?  No.  Am I moved?  Yes.

#16 out of 50.


Comments for this post are closed