prospect theory into a formal pricing model may help us understand the
level of average returns. While our work confirms this, we find that loss
aversion cannot by itselfexplain the equity premium; incorporating the ef-
fect of prior outcomes is a critical ingredient as well. To see this, we also ex-
amine a simpler model where prior outcomes are ignored and hence where
the pain of a loss is the same, regardless of past history. The investor’s risk
aversion is then constant over time, and stock prices lose an important
source of volatility. With less volatile returns and hence less risk, we are no
longer able to produce a substantial equity premium.
Another set of papers, including Barberis, Shleifer, and Vishny (1998)
and Daniel, Hirshleifer, and Subrahmanyam (1998), explains some empiri-
cal features of asset returns by assuming that investors exhibit irrationality
when making forecasts of quantities such as cash flows. Other papers, in-
cluding Hong and Stein (1999), suppose that investors are only able to pro-
cess subsets of available information. Here, we take a different approach.
While we do modify the investor’s preferences to reflect experimental evi-
dence about the sources of utility, the investor remains rational and dynam-
ically consistent throughout.^3
In section 2 we show how loss aversion over financial wealth fluctuations
and the effect of prior outcomes can be introduced into an asset pricing
framework. Section 3, discusses studies in the psychology literature that we
draw on in specifying the model. Section 4 characterizes equilibrium asset
prices and presents intuition for the results. In section 5 we investigate the
model’s ability to explain the aggregate data through a detailed numerical
analysis. In section 6 we examine the importance of taking account of prior
outcomes by analyzing a simpler model where they are ignored. Section 7
concludes.
2 .Investor PreferencesOur starting point is the traditional consumption-based asset pricing model
of Lucas (1978). There is a continuum of identical infinitely lived agents in
the economy, with a total mass of one, and two assets: a risk-free asset in
zero net supply, paying a gross interest rate of Rf,tbetween time tand t+1;
and one unit of a risky asset, paying a gross return of Rt+ 1 between time t
and t+1. In the usual way, the risky asset—stock—is a claim to a stream of
perishable output represented by the dividend sequence {Dt}, where divi-
dend growth is given by
(1)where t+ 1 ∼i.i.d. N(0,1).
log(DD gtt DDt++ 11 / )=+σ ,PROSPECT THEORY AND ASSET PRICES 227(^3) See Shleifer (1999) for a recent treatment of irrationality in financial markets.