Asian Review of Financial Research Vol.30 No.4 pp.479-517
An Empirical Study of Cumulative Prospect Theory in the Korean Stock Market
Key Words : Cumulative Prospect Theory,Probability Weighting,Lottery Preference,Skewness Preference,Behavior-Finance
This study tests whether cumulative prospect theory (Tversky and Kahneman, 1992) captures investors' psychological evaluations of individual stocks. It also tests the hypothesis that investors mentally evaluate a stock based on the historical distribution of returns. This study's major empirical findings are as follows. First, when evaluated only on positive terms (henceforth TK+) of the past 36 monthly market excess returns, cumulative prospect theory value shows a negative correlation with subsequent returns. Second, a long-short portfolio sorted on TK+ earns a return of 1.197% on average per month and remains significant for six months after the portfolio's formation. Moreover, the return predictability of TK+ remains significant even if we consider several wellknown control variables, such as beta, size, b/m ratio and momentum, and skewness-related variables. Finally, we find empirical support for the hypothesis that the probability weighting of cumulative prospect theory plays an important role in investors' preferences for lottery-like stocks. This study demonstrates that behavioral finance can be applied to the Korean stock market using statistical analysis.