This is an extensive summary. The research questions are explained, the underlying intuition, my comment about it, is provided and the main methodology is given. In this summary you can find a sentence or two about each graph and figure based on the authors conclusion. I also added some comments fr...
Title: Prospect Theory and Stock Returns: An Empirical Test
Authors: Nicholas Barberis - Yale School of Management; Abhiroop Mukherjee - Hong Kong
University of Science and Technology; Baolian Wang - Fordham University
- 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.
2. Research Question + underlying intuition
Research Question: Can models in which some investors evaluate risk according to prospect theory
help us make more sense of the data on asset prices and asset returns?
Underlying intuition: The main empirical prediction is that stocks whose historical return
distributions have high (low) prospect theory values will have low (high) subsequent returns. We
expect this prediction to hold primarily among small-cap stocks, in other words, among stocks for
which individual investors play a more important role.
My understanding
High prospective theory value means that the investors are risk averse and they avoid taking risk. In
this case they want to buy the stock with high past returns. Low prospective theory value means that
the past returns are low and the investors are going away from the stock. So, the model shows that
stocks with low historical returns will have higher returns in the future and conversely higher stock
returns will have lower returns in the future. The intuition behind is that investors will buy stocks
with high past returns and they will become overvalued and therefore earn low subsequent returns.
From article
In this paper, we test the pricing implications of the joint hypothesis laid out above: that some
investors in the economy think about stocks in terms of their historical return distributions; and that
they evaluate these distributions according to prospect theory.
,Another hypothesis: A stock whose future returns are expected to be positively skewed will be
“overpriced” and will earn a lower average return.
A positively skewed investment return means there were frequent small losses and a few
large gains.
Negatively skewed means there were frequent small gains and a few large losses.
3. Main methodology
1. Conceptual Framework
1.1 Prospect theory
Figure 1 The prospect theory value function and probability weighting function
1.2 Construction of return distributions
1.3 Model
Proposition 1
2. Empirical Analysis
2.1 Data
Table 1 Data summary
2.2 Time-series tests
Table 2 Decile portfolio analysis
Figure 2 Performance of TK deciles
Figure 3 How do the long-short portfolio returns decline over time?
Table 3 Factor loadings
2.3 Robustness of time-series results
Table 4 Robustness
2.4 Fama-MacBeth tests
Table 5 Fama-MacBeth regression analysis
2.5 The role of limits to arbitrage
Table 6 Double sorts
Table 7 Fama-MacBeth analysis of limits to arbitrage
2.6 International evidence
Table 8 Quintile portfolio analysis in forty-six international stock markets
2.7 Mechanism
Table 9 Characteristics of TK portfolios
Table 10 Fama-MacBeth regressions using different components of prospect theory
Table 11 Fama-MacBeth regressions that vary the degree of probability weighting
4. Conclusion
- 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.
Prospect theory is a behavioral economic theory that describes the way people choose
between probabilistic alternatives that involve risk, where the probabilities of outcomes are
known.
Research Question: Can models in which some investors evaluate risk according to prospect theory
help us make more sense of the data on asset prices and asset returns?
- In this paper, we present new evidence on this question. We derive the predictions, for the
cross-section of stock returns, of a simple prospect theory-based model and test these
predictions in both U.S. and international data.
- We suggest that, for many investors, their mental representation of a stock is the distribution
of the stock’s past returns.
- In this paper, we test the pricing implications of the joint hypothesis laid out above: that
some investors in the economy think about stocks in terms of their historical return
distributions; and that they evaluate these distributions according to prospect theory.
- To understand the implications of this hypothesis, we construct a simple model of asset
prices in which some investors allocate money across stocks in the following way.
o For each stock in the cross-section, they take the stock’s historical return distribution
and compute the prospect theory value of this distribution.
o If the prospect theory value is high, they incline toward the stock in their portfolios;
by assumption, the stock is appealing to these investors.
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