Explaining Returns with Loss Aversion

Tyler Shumway
December 29, 1997


I develop and test an equilibrium asset pricing model based on loss averse investors. The model specifies a pricing kernel that is a nonmonotonic function of the market return. It also implies that investors demand a higher risk premium for risk associated with negative market returns than for positive market returns. The model assumes rational expectations and is consistent with no-arbitrage pricing.

Estimates of the model's parameters are similar to values reported elsewhere. As the loss aversion literature predicts, the accuracy of the model depends on the frequency with which data is observed. Consistent with Benartzi and Thaler (1995), the model explains annual returns better than competing models, but it does not explain monthly, quarterly, or half-year returns. The model fits both returns that reflect the equity premium and stock returns alone.

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