Two features distinguish the behavioral approach to asset pricing from the traditional approach to asset pricing. The first feature is sentiment. Proponents of behavioral finance treat sentiment as a major determinant of market prices, stemming from systematic errors committed by investors. Proponents of traditional finance treat sentiment as minor. Instead, they assume that investors by and large are free from bias in their use of available information. Whereas behavioral asset pricing theorists attribute observed pricing phenomena to sentiment, traditional asset pricing theorists attribute observed pricing phenomena to fundamental risk or time varying risk aversion.

The second feature that distinguishes the behavioral approach and traditional approach is the assumption of expected utility. Traditional asset pricing theorists assume that investors seek to maximize expected utility. There is good reason to do so, in that expected utility is a rationality-based framework. Indeed, to this point, the expected utility assumption has been central to the analysis. However, proponents of behavioral finance are critical of expected utility as a descriptive theory. They suggest that people generally behave in ways that are inconsistent with expected utility theory. Instead, they suggest that people behave more in accordance with a psychologically based theory, such as prospect theory. Prospect theory was developed by Kahneman and Tversky (1979).

Prospect theory is the subject of this chapter. The chapter describes...