Prospect theory: evidence of over-reaction in investor decision making at the Nairobi stock exchange

Abstract

Overreaction is a common investor problem that heavily occurs due to irrationality on the part of the investor. According to Kahneman and Tversky, investors tend to be risk seeking in losses and risk averse in gains, a realization that led to the genesis of the Prospect Theory. Moreover, studies have identified that the Efficient Market Hypothesis is not a perfect tool in determining investor reaction. Therefore this study purposed to analyze the existence of overreaction in the Nairobi Securities Exchange through use of a model Swallow {1998) that analyzes stock abnormal returns, checks for their persistency and also examines if they are driven by overreaction. According to the findings, the market was deemed to be in the weak form of efficiency hence abnormal returns being experienced were persistent. Further, overreaction was observed in losses and not in gains, hence affirming the findings of the Prospect Theory. Overall, in comparison to the Portuguese market, similar findings were obtained hence leading to the conclusion that behavioral biases do play a role in investor decision making and it is imperative for investors to be well educated before investing and to take up effective hedging strategies to mitigate against the negative effects of stock losses