A behavioral representative investor who evaluates a single risky asset based on cumulative prospect theory will often induce high kurtosis, negative skewness, and persistent autocorrelation into the distribution of market returns even if the asset payoffs are merely a sequence of independent coin tosses. These findings continue to hold even when the investor is simply loss averse.

In previous models of (cumulative) prospect theory reference-dependence of preferences is imposed beforehand and the location of the reference point is exogenously determined. This note provides a foundation of prospect theory, where reference-dependence is derived from preference conditions and a unique reference point arises endogenously.

Prospect theory is an influential psychological theory that describes how individuals make decisions involving risk. One of its key findings is that decision-makers are risk averse when in a ―domain of gain‖ (when they have experienced success), and risk acceptant when in a ―domain of loss‖ (when they have experienced setbacks). In this paper, I use prospect theory to examine George H. W. Bush’...