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.