a single risky asset. In a more realistic economy with many risky assets, it is
not immediately clear what investors are loss averse about: do they feel loss
averse over changes in the value of individual securities that they own, or
only over portfolio fluctuations? In essence, this is a question about how
people summarize and think about their investment performance, or about
how they do their “mental accounting,” in the language of psychology. How
mental accounting affects asset prices is as yet an unexplored topic.
Another question that may warrant further study asks to what extent our
preferences can explain not only financial data but also experimental evi-
dence on attitudes to risky gambles. In order to explain the high equity pre-
mium, consumption-based models typically assume a high curvature of
utility over consumption. As is well-known, this high curvature is consis-
tent with attitudes to small-scale gambles, but unfortunately also predicts
that people will reject extremely attractive large-scale gambles.^28 In our
model, we do not use a high curvature of utility of consumption, and the
loss aversion we assume is not far from that estimated from experimental
evidence. This offers the intriguing possibility that preferences of the kind
studied here may be able to reconcile attitudes to both large- and small-
scale gambles with the empirical facts about stock returns.
PROSPECT THEORY AND ASSET PRICES 265(^28) See, for example, Epstein and Zin (1990) and Kandel and Stambaugh (1991).