Applications of Regret theory to asset pricing

Abstract

This paper presents a theoretical model of asset pricing that analyses how the behavior of stock returns is affected by the presence of regret averse investors on the market. Regret aversion is a well established psychological theory that suggests that some people have regrets when they see that their decisions turn out to be wrong even if they appeared correct with information available ex-ante. The idea of regret extends naturally to finance by assuming that investors compare their returns with exogenous benchmarks. Using this assumption, the model predicts that the market will over-react on good or bad news, so that there will be an excess volatility of stock returns. It also helps to explain such wellestablished empirical puzzles as the positive short-run and negative long-run autocorrelation of stock returns and it predicts a positive correlation between future trading volume and the dispersion of the realized stock returns. In addition to that, the framework developed in this paper helps to analyze how an improvement of stock market accessibility for non-professional traders affects the predictability of stock returns. Using recent stock market data the second part of the paper provides an empirical analysis of some of the model’s implications. I am especially grateful to Roger Gordon for his advice and numerous detailed comments. I also thank

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