Prospect Theory and Stock Returns: A Test for Trading Behavior of Individual VS. Institutional Investors

Since the 1980s, prospect theory has been showed to have predictive power in various financial markets. It has been commonly accepted that prospect theory describes how people evaluate financial assets when making investment decisions. Using a regulatory change in the Chinese B-share market as an exogenous shock, we directly test the different trading behaviors between individual and institutional investors. The empirical evidences show that after the regulatory change, the predictive power of prospect theory becomes significantly stronger in the B-share market, providing strong evidence that individual investors rely more on prospect theory when making investment decisions. This change of the predictive power of prospect theory for B-share market mainly comes from the probability weighting component, which reflects the “lottery-type” and “insurance-type” demands of investors.