Irrational Investor Behavior from a Prospect Theory Perspective: An Analysis of the Chinese Stock Market

Abstract

Traditional finance generally takes rational decision-making and market efficiency as its starting point, assuming that investors process information rationally. In actual trading, however, investors are influenced by reference points, their response to losses, and subjective judgment. Focusing on the Chinese stock market, this paper reviews and compares existing studies to explain prospect theory through three elements: the value function, loss aversion, and decision weights. It then discusses the disposition effect, differences across investor groups, and heterogeneous beliefs. The literature shows that individual investors are especially susceptible to behavioral biases because of limits on attention and information processing. Institutional investors may also be influenced by agency problems, performance evaluation, and organizational decision-making. Prospect theory extends traditional financial models by offering a better account of actual choices, but whether individual biases develop into persistent market anomalies also depends on how information spreads, trading constraints, and the strength of arbitrage.