Asset Prices Under Prospect Theory and Habit Formation

In this paper, we develop a consumption-based asset pricing model motivated by prospect theory, where habit formation determines the endogenous reference point. This exploits the similarity between habit formation and prospect theory. Both emphasize that the investor does not care about the absolute amount of gain or loss, but rather compares the gain or the loss experienced to a benchmark. The results show that when taking people’s loss averse attitude over consumption into consideration, our model is capable of resolving the equity premium puzzle.