“PROSPECT theory” is an important contribution to the study of economics. It challenges some of the fundamental assumptions that economists have made concerning human behaviour. Daniel Kahneman, one of the researchers behind the idea, won a Nobel Prize in Economics for his work. But one of the longstanding jokes in the economics profession is that, since prospect theory was proposed in 1979, it has had little impact on real world problems. A new paper by Nicholas Barberis, an economist at Yale, finds this consensus dismaying. Mr Barberis shows that prospect theory has actually influenced the study of finance—and it can explain some of the central puzzles of how markets work….
The villain… is “expected utility theory”… [which] says that people are good at assessing probabilities… [and that] it is as pleasurable to find £5 on the street, as it is painful to lose £5. Prospect theory… shows that people are in fact terrible at assessing probabilities… find bad things relatively worse than they find good things good…. Prospect theory is rather abstract. Its equations are enough to put anyone off. But it is useful in tackling some of the longstanding puzzles of financial markets.
One conundrum concerns average returns. Why do some securities consistently have lower returns than others?…. Prospect theory… [notes] stocks with the lowest returns are those with the highest “positive skewness”…. If a stock has positive skewness, investors are entranced by the chance—even the very smallest chance—of becoming very wealthy…. The stock they own could just be the next Microsoft. It almost definitely will not be, but investors are poor at assessing future probabilities. Due to this poor “probability weighting”, investors overweight the unlikely state of the world in which they make a lot of money….
The longstanding difference between the rate of return of stock market and government bonds is also puzzling. For most of the 20th century, the rate of return for government bonds was around 6 percentage points lower than that for stocks. Traditional consumption-based models of asset prices which rely on expected utility theory cannot account for this disparity. But prospect theory can. Investors find the idea of losing more painful than they find the idea of winning pleasurable…. Buying stocks could lead to losses…