Behavioral Preferences as Potential Asset Pricing Factors

Summary

The document explores whether behavioral preferences could shape asset pricing models and help explain differences in expected returns beyond conventional risk factors. It asks whether ideas from Prospect Theory, including loss aversion and sensitivity to lottery-like positive skewness, might alter how beta is derived or lead to distinct risk premia. It also raises possible factors linked to time-inconsistent discounting, local investor preferences, and disposition effects.

The author asks whether such factors could be derived from first principles in a manner comparable to the CAPM’s market beta. The discussion cites conversations and recent academic work as motivation, while noting uncertainty about industry recognition. It does not propose a formal model, define measurable factor portfolios, or provide empirical tests. The examples are hypotheses for research rather than established explanations of the cross-section of returns, and the document leaves open how to identify or quantify any behavioral premium.

Key ideas

• Prospect Theory may motivate asset pricing hypotheses involving loss aversion and skewness preferences.
• Behavioral effects such as time inconsistency or home bias could potentially relate to return differences.
• The author seeks a first-principles derivation of behavioral factors analogous to CAPM beta.
• The proposed premiums are exploratory ideas, not validated factors in this document.
• Empirical definitions and tests would be needed to assess their explanatory power.

Tags

# CAPM and Beta under Prospect Theory


# CAPM and Beta under Prospect Theory












I'm thinking about some sort of behavioral risk factors such as whether different utility functions, such as Prospect Theory according to Kahneman and Tversky, might change the way betas are derived and formulated and whether there are risk factors such as - say- some sort of loss aversion risk premium and such. From behavioral finance, we already know that there seems to be a pricing impact of lottery-like stock-features aka idiosyncratic positive skewness..

I just wonder whether there are some underlying drivers that might explain the cross section of returns better than the classical risk factors...such as e.g. some "time-inconsistency premium" for assets that pay profits earlier (if hyperbolic discounting is of some importance), some sort of "home bias discount" for stocks that have a large share of local investors holding these or some "loss aversion preium" and "disposition effect factor" etc. pp.

Is there a more "from-scratch-way" to derive some of the factors similar to the CAPM derivation for market Beta? I'm not sure whether my thoughts are totally absurd as a recent chat with Harald Lohre revealed that such behavioral factors are not recognized in the industry yet, however, academics such as David Hirshleifer, with who i also spoke lately, recently published a paper on this topic..(thats why i post it here- curious about your opinion) :-)

PS: sorry for any typos, i'm typing with chubby fingers on my microscopically-small mobile screen

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.