Prospect theory, introduced by Kahneman and Tversky in 1979, is a pivotal framework for understanding decision-making when investors exhibit cognitive biases under uncertainty. This theory is particularly notable for its insights into how investors weigh gains and losses: they demonstrate a heightened sensitivity to losses compared to equivalent gains, a phenomenon known as loss aversion. Consequently, investor behaviour varies with risk—typically risk-averse when considering potential gains and risk-seeking when facing potential losses, a trait attributed to diminishing sensitivity. A 2016 investigation by Barberis and colleagues highlighted how investors employ past return distributions as a heuristic for determining prospect theory values for stocks anchored on prospective utility. This approach to decision-making utilises past performance as a proxy for future expectations, embedding representativeness in their calculations.

Building on this foundation, a recent empirical study led by Professor Cheoljun Eom from the School of Business at Pusan National University, Korea, delved into whether values derived from prospect theory, based on past 12-month return distributions, can predict the persistence of stock performance across different stocks in subsequent periods. To enhance the applicability of these findings, the research team developed a novel metric, the Cross-Sectional Prospect Theory Value (CSPTV). This new metric facilitates comparisons across different stocks, unlike the traditional Prospect Theory Value (PTV) confined to individual stocks. The findings were published online on 15 February 2024 and later in the May 2024 issue of the International Review of Financial Analysis.

Professor Eom notes, “Our findings compellingly demonstrate that CSPTV surpasses traditional PTV in forecasting the persistence of stock performance.” The implications of this research are multifaceted. Primarily, it corroborates the predictive utility of CSPTVs derived from past 12-month return distributions for future performance periods. The introduction of CSPTV marks a significant expansion in the application of prospect theory to cross-sectional stock returns, providing a broader analytical lens compared to the previous 12-month focus. Additionally, this metric offers a more nuanced understanding of how investors’ tendencies to juxtapose gains and losses influence stock evaluations, enhancing the predictive capacity of prospect theory across different stocks.

The study also reaffirms that these theoretical values can elucidate both momentum and disposition effects observed within the same timeframe, thereby underscoring prospect theory-based portfolios’ unique and valuable insights. In conclusion, Professor Eom expresses optimism about the broader implications of their CSPTV framework, stating, “This enhancement not only broadens the application of existing prospect theory analyses to encompass cross-sectional returns but also significantly boosts their predictive efficacy.”

More information: Cheoljun Eom et al, Intermediate cross-sectional prospect theory value in stock markets: A novel method, International Review of Financial Analysis. DOI: 10.1016/j.irfa.2024.103120

Journal information: International Review of Financial Analysis Provided by Pusan National University