Working Paper: NBER ID: w7220
Authors: Nicholas Barberis; Ming Huang; Tano Santos
Abstract: We propose a new framework for pricing assets, derived in part from the traditional consumption-based approach, but which also incorporates two long-standing ideas in psychology: prospect theory, and evidence on how prior outcomes affect risky choice. Consistent with prospect theory, the investor in our model derives utility not only from consumption levels but also from changes in the value of his financial wealth. He is much more sensitive to reductions in wealth than to increases, the ``loss-aversion'' feature of prospect utility. Moreover consistent with experimental evidence, the utility he receives from gains and losses in wealth depends on his prior investment outcomes; prior gains cushion subsequent losses -- the so-called 'house-money' effect -- while prior losses intensify the pain of subsequent shortfalls. We study asset prices in the presence of agents with preferences of this type, and find that our model reproduces the high mean, volatility, and predictability of stock returns. The key to our results is that the agent's risk-aversion changes over time as a function of his investment performance. This makes prices much more volatile than underlying dividends and together with the investor's loss-aversion, leads to large equity premia. Our results obtain with reasonable values for all parameters.
Keywords: No keywords provided
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| changing risk aversion (D81) | asset prices (G19) |
| prior investment performance (G11) | risk attitudes (D81) |
| prior gains (G14) | lower risk aversion (D81) |
| prior losses (G33) | higher risk aversion (D81) |
| lower risk aversion (D81) | higher asset prices (G19) |
| higher risk aversion (D81) | lower returns (G19) |