Investigating Indian Retail Investor Behavior through the lens of Prospect Theory

Abstract

The paper explores how prospect theory of loss aversion (Kahneman & Tversky 1979) can help explain retail investor behavior in India with respect to small-cap and mid-cap stocks during periods of crisis which may influence emotional sentiments as well as stock markets. Two distinctly separate periods were analyzed and compared: the Great Recession (2008-09) and the COVID-19 global pandemic (2020-21). A combination of qualitative and quantitative methods was used – a literature review of past studies, detailed interviews with experts, and cross-correlation analysis sentiment and market indices. Statistical correlation analysis of investor sentiment was done versus stock market index movement during the two time periods. Results indicate that positive sentiment and negative sentiment have immediate-term positive and negative relationship respectively with investor behavior, and how loss aversion was stronger during 2008 than 2020. Study also identifies differences in reference points between the two periods, which is consistent with prospect theory in terms of the role of reference point in determining degree of loss-aversion. Expert interviews identified multiple factors such as prior experience with market losses, governmental actions, younger demographics, easier market participation due to technology in 2020 caused the reference point to be different from 2008. Further research needed to understand why the sentiments have an immediate effect on investor behaviors but not in future periods. In contrast, movements in stock markets were seen to have both immediate and future period relationships with sentiment, which suggest some role of herding which needs to be further investigated in future studies.