Solving some financial puzzles with prospect theory and mental accounting: A survey

Abstract

Many financial puzzles have been solved, at least partially, by the introduction of alternative assumptions on the behaviour of investors. Cumulative prospect theory and mental accounting are two such approaches which are used in this paper to analyze some of the most important financial puzzles. We first focus our attention on two anomalies (or considered as such in the standard expected utility model) at the individual level, the disposition effect and the low diversification puzzle. We then address two aggregate puzzles, namely the equity premium puzzle and the return predictability puzzle. We show how and why recent behavioral models contribute to explain these anomalies in a very natural way.