Prospect theory can explain many stock anomalies

 

One of the problems of behavioral finance research is that there is no unified approach or model that can explain all the anomalies that exist in the stock market. Some behavioral models can explain one or two anomalies, yet they may contradict other anomalies. I accept that this is a part of the scientific process, but it limits the usefulness of this research. 

It looks like we have a model based on prospect theory that can explain many stock anomalies. See "Prospect Theory and Stock Market Anomalies". This exhaustive paper means that prospect theory should be at the forefront of thinking about how investors behave.

Prospect theory was developed by Kahneman and Tversky to explain decision-making under risk. Prospect theory states that investors will evaluate risks based on gains and losses with a kink at the origin. Investors will be more sensitive to losses than to gains. The sensitivity is concave over gains and convex over losses; risk aversion for gains and risk seeking over losses. There is loss aversion and narrow framing.

The price of an asset in a prospect theory world will be dependent on (1) asset return volatility, (2) skewness, and (3) the average prior gain or loss since purchase, the capital gain overhang. Investors require (1) higher average return for higher volatility, (2) lower average return for positive skew, and (3) higher average return for assets with larger prior gains. 

According to the author's testing, prospect theory can explain: momentum, failure probability, idiosyncratic volatility, gross profitability, expected idiosyncratic skewness, return on assets, capital gain overhang, maximum daily return, z-score, external finance, composite equity issuance, net stock issuance, post-earnings announcement drift, and difference of opinion anomalies. 

Forming deciled portfolios for each of the tested anomalies, the authors find the same pattern, the extreme decile with lower returns has higher volatility, more positive skew, and a lower capital gain overhang relative to the other extreme decile. Prospect theory cannot explain the size and value anomalies.

The research provides powerful evidence for thinking about investor behavior in a prospect theory world. The null should be that investors will follow the expected behavior embedded in prospect theory - loss aversion, kinked behavior around the purchase price and capital overhang.