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1 Introduction
It is widely accepted and empirically demonstrated that the rational expectations theory and the efficient markets hypothesis do not generally hold for various suggested reasons. Thus, there is a growing acceptance of alternative behavioral finance theories ([7] Ritter, 2003). If investors and traders were all rational beings whose investing decisions were logically based on the information available, then a particular event would precipitate predictable and unanimous reactions every time. But trading is not a precise science. Each event causes varied reactions and predictions, which effectively amount to sheer speculation, or forecast error, where "permanent and widespread psychological biases affect both the subjective probability of future economic events and their retrospective interpretation" ([2] Bovi, 2009). Emotional and psychological factors often override the rational expectations theory in financial decision making, affecting trading performance ([6] Lo et al. , 2005), and only if risk aversion is pegged at unrealistically high levels, does the efficient market hypothesis and rational expectations theory explain the volatility of the market overall ([8] Shiller, 2003).
The psychological factors that interfere with rational thinking include cognitive biases such as heuristics, overconfidence, mental accounting, framing, representativeness, the conservatism and disposition effect ([7] Ritter, 2003), and the overall emotional reactivity ([6] Lo et al. , 2005). There are also other factors that skew decisions, such as misevaluations of financial assets ([7] Ritter, 2003), lack of understanding and miscalculation of basic financial measures, such as volatility ([3] Goldstein and Taleb, 2007), and finally, the effect of word of mouth and media driven feedback ([8] Shiller, 2003).
Unfortunately, "psychology is silent on the magnitude of the biases and on whether the effects of the biases are constant over time and/or are homogeneous across individuals" ([2] Bovi, 2009), so that this inability to generalize hampers the opportunities for a meaningful hypothesis testing in this regard.
In addition, the theoretical and empirical models based on the efficient market hypothesis usually adopt the a priori assumption of risk aversion. Examples include the capital asset pricing model (CAPM) and the mean variance model.
Prospect theory was introduced as an alternative to expected utility theory, rational expectations theory and the efficient market hypothesis. Prospect theory postulates that decision makers prefer certain outcomes over probable outcomes, called the certainty effect, which...