A new method that implements the investment decision of the utility of the prospect theory towards stock markets

Prospect theory, proposed by Kahneman and Tversky in 1979, has been recognized as an excellent decision theory for the limited rationality of investors who tend to show cognitive bias under conditions of uncertainty. Regarding gains and losses in prospect theory, investors tend to be more sensitive to losses than gains of equal magnitude (loss aversion). Together, they show different risk attitudes: risk aversion in the case of gain and risk seeking in the case of loss (decreased sensitivity).

According to a 2016 study by Baberis and team., Under the premise of prospective utility, investors determine the values ​​of the prospect theory for stocks using past return distributions as a representative heuristic. The study defines the last 12-month return distributions as the heuristic of the investor’s decision based on the prospect theory.

Accordingly, a group of researchers led by Professor Cheoljun Eom from the Business School of Pusan ​​National University, Korea, recently empirically investigated whether the prospect theory values ​​from the return distributions of the last 12 months they have the power to predict performance persistence for the cross section. stock returns in future holding periods.

In addition, as methods of measuring prospect theory values ​​for cross-sectional stock returns improve, a new measurement of cross-sectional prospect theory value (CSPTV) has been devised to enable the cross-sectional comparison between actions, compared to the value of the existing perspective theory. (PTV) specific to a single stock. His study was available online in the International Journal of Financial Analysis on May 1, 2024.

“Our work robustly demonstrates the ability of CSPTV to outperform PTV in terms of predictive power of performance persistence,” remarks Prof. Eom.

The present study, through its research objectives and results, is expected to make contributions on several fronts. First, it shows the predictive power of performance persistence over future holding periods using PTVs from past 12-month return distributions. In particular, the scope of prospect theory for cross-sectional stock returns in stock markets has been successfully expanded over the past 12 months.

In addition, this work designs a CSPTV that reflects investors’ tendency to compare gains and losses among cross-sectional stocks, unlike the specific PTV for a single stock. The comparative advantage of CSPTV in better capturing the predictive power of prospect theory compared to PTV is thus empirically proven. .

Finally, this study confirms that the PTVs of the last 12 months can explain the effects of momentum and disposition observed during the same period. This means that the value of information in a prospect theory portfolio has been robustly proven to be unique and not redundant for the above effects.

Professor Eom concludes: “Overall, we anticipate differentiated contributions from the CSPTV design, which will expand the scope of existing prospect theory to the 12-month past return distribution and improve the predictive power of prospect theory in cross-sectional stock returns.”