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Top1. Introduction
Prospect theory is an aspect of behavioral economics which describes how people choose between alternatives involving risk. The presumption is that these alternatives are probabilistic, and these probabilities are known. This study aims to take advantage of prospect theory to understand consumer behavior in stock markets. Quantifiable metrics for consumer behavior are gauged to draw a reference to prospect theory and qualitatively analyze consumer behavior.
Stock markets serve as an efficient indicator of the future economic trends and policy decisions. These patterns account for consumers’ saving pattern and consequently, their propensity to spend, while also reflecting on the leading sectors of the economy and capital investment in this context simultaneously. However, the decision of an individual to buy or sell stocks is not merely the product of purely rational, carefully calculated estimates that seek to predict future highs or lows. It is only natural that their decision also reflects a strong intuitive influence drawing on their past experiences, and it is this factor that is often neglected in traditional economic models of consumer behavior. This is the most likely cause for the inadequacy of these models in explaining empirical facts. Prospect theory realizes that the motivation behind the purchase or sale of stocks may be beyond the exclusive economic realm. The questions raised and dealt with in the domain of behavioral economics have proven to be of increasing inter-disciplinary interest, owing primarily to the fact that these issues have a strong bearing on real world issues and the solutions proposed can be more or less directly applied in actual implementation. Operating on the fairly well-established principles of this field, prospect theory aims to model this component building on the tenets of cognitive psychology to understand how their individual reactions justify the end goal of higher returns and financial stability.
Conventionally, aggregate stock market behavior has been analyzed from the consumption standpoint by Hansen and Singleton (1983), Mehra and Prescott (1985), and Hansen and Jagannathan (1991). This has presented a two-fold problem: (1) It fails to explain the historically high returns and volatility and (2) It can’t substantiate for striking variation in time-series stock market returns’ analyses.
Some areas which were proposed to better capture the investor behavior included the utility framework but further included some areas of the prospect theory. One, investors are more sensitive to reductions in financial wealth than gains, also termed as loss aversion. This means that if an investor A experiences a gain now that equals the amount of loss incurred earlier, the situation is not equivalent to an investor B who has experienced no loss or no gain. Although they stand on equal footing from the point of view financial accounting, their decisions will probably be guided by differing motivations. For this case specifically, investor A is likely to be more loss averse while making future investment decisions. However, another important consideration comes into play in this regard. The second concern is that the extent to which an investor exhibits this loss aversion depends on previous investment performance. Prior gains would make the investor less averse to losses as the gains may offset the potential losses and prior losses would make the investor more sensitive to future reductions in financial wealth.
Barberis et al. (1998) in their study suggested that these empirical metrics for stock market returns are weakly correlated to consumption. In their framework, dividends are assumed to be the sole driver for equity performance which has very weak correlation with dividends.