The Prospect Theory and The Stock Market

Abstract

This paper is aimed to investigate the important principle of behavioral economics , prospect theory and applies prospect theory to stock market. Based on the former studies, there are three features at the core of prospect theory, and they are in turn the reference point, a principle of diminishing sensitivity and loss aversion. Prospect theory focus on how people make decisions in an uncertain situation and it combines psychology to research economic man's choice behavior rather than research rational people’s economic behavior like expected utility theory. Therefore, the prospect theory has more value and more practical to apply in the stock market and be studied to predict investors behavior. In this essay, case analysis method and theoretical analysis method will be used to explore the prospect theory and stock market. It found that prospect theory can conduct investors gain more profit because of stock reverse transaction strategy. And loss aversion, the most important factor of reversal effect, point out that when face the uncertainty, people won’t keep completely rational as the utility theory said. What’s more, it suggests the exist of reverse effect in Chinese stock market. The research contributed to present understanding of the prospect theory in China's stock market, and further explores that the stock reversal strategy is more conducive to investors' profits in China's stock market. A large part of the reasons for this phenomenon can be explained by prospect theory, while expected utility theory cannot.