Prospect theory, proposed by Kahneman and Tversky in 1979, has been acknowledged as an excellent decision-making theory for the bounded rationality of investors tending to show cognitive bias under conditions of uncertainty. In terms of gains and losses in prospect theory, investors tend to be more sensitive to losses than equal-magnitude gains (loss aversion). Together, they show different risk attitudes: risk-averse in the case of gains and risk-seeking in the case of loss (diminishing sensitivity).

According to a 2016 study by Baberis and team., under the premise of prospective utility, investors determine the values of prospect theory for stocks using past return distributions as a representativeness heuristic. The study defines the past 12-month return distributions as the heuristic of investor decision-making based on prospect theory.

Accordingly, a group of researchers led by Professor Cheoljun Eom from the School of Business at Pusan National University, Korea, recently empirically investigated whether prospect theory values from the past 12-month return distributions have the power to predict performance persistence for the cross-sectional returns of stocks in future holding periods.

Furthermore, as the methods measuring the values of prospect theory for cross-sectional stock returns improve, they devised a new measurement of cross-sectional prospect theory value (CSPTV) to enable cross-sectional comparison among stocks, compared with the existing prospect theory value (PTV) specific to a single stock. Their study was made available online in the International Review of Financial Analysis on 1 May 2024.

"Our work robustly demonstrates the ability of CSPTV to outdo PTV in terms of predictive power of performance persistence," remarks Prof. Eom.

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