Prospect theory and stock returns: Evidence from foreign share markets

Exploiting an exogenous regulatory shock in a foreign share market, we investigate its impacts on ownership structure and investor behaviors, and assess the ability of prospect theory to explain these behaviors and stock prices. We find that prospect theory values have strong predictive power for returns in the B-share market after the reform that attracts large inflows of individual investors. Changes in predictive power are driven by the probability weighting component in prospect theory value, reflecting the lottery-type demand of these individual investors. Results provide direct evidence that individual investors are prone to the mental presentation effect when evaluating risk.

Automated summary

The study examines the impacts of an exogenous regulatory shock in a foreign share market on ownership structure and investor behaviors, and evaluates the explanatory power of prospect theory for these behaviors and stock prices. Results indicate that prospect theory values have strong predictive power for returns in the B-share market, with changes in predictive power being driven by the probability weighting component, reflecting the lottery-type demand of individual investors. The study provides direct evidence that individual investors are influenced by the mental presentation effect when evaluating risk.