The prospect theory and the idiosyncratic risk-return linkage: a quantile regression approach for Vietnam’s stock market

Abstract

Purpose

This paper scrutinizes the relationship between idiosyncratic risks and stock returns at different quantiles, especially the extremely low and high ones, to explore the applicability of the Prospect Theory’s rationale in Vietnam’s stock market.

Design/methodology/approach

The Prospect Theory demonstrates that investors’ attitudes towards risks can change from risk-seeking in the loss domain to risk-averse in the gain domain. This can be observed by the negative (positive) connection between idiosyncratic risks and returns for the losing (winning) stocks. To explore if the aforesaid patterns occur in Vietnam’s stock market, this paper employs the quantile regression method which is suitable for inspecting the relationship at the high and low tails of the stock returns.

Findings

The estimation results acknowledge the changes in attitudes towards risks as mentioned by the Prospect Theory.

Practical implications

The negative relationship between idiosyncratic risks and stock returns confirms investors’ risk-seeking behavior in the loss domain, which is in line with the prediction of the Prospect Theory. This behavior may cause worse investment performance as the losing stocks in investors’ portfolios remain overvalued, leading to subsequent negative returns. Therefore, investors should establish and follow their investment disciplines to protect themselves from larger losses.

Originality/value

Existing research found little evidence for the Prospect Theory’s rationale in Vietnam’s stock market, which can stem from the usage of the conditional-mean regression methods. Different from the prior studies, this paper is the first to apply the quantile regression method and provide new evidence supporting the Prospect Theory’s rationale in Vietnam’s stock market.