A New Momentum and Reversal under Prospect Theory: Introduction and Their Implications

Abstract

Based on the prospect theory value (TK value) by Barberis et al. (2014), I construct new Short-term TK by using the previous 12-month returns and Extreme TK by using only 20 extreme returns among 60-month historical returns. Although stocks with a high original TK generate low subsequent returns (reversal), stocks with high Short-term TK generate high subsequent returns (momentum). This new momentum is distinguished from price momentum, and helps to decompose the causes of price momentum into underreaction and delayed overreaction. Furthermore, Extreme TK persistently generates a larger reversal than the original TK. Also with more sophisticated analysis, I show that Extreme TK is a lottery proxy variable, whereas the original TK is not.