Prospect theory and stock price behavior in retail trading booms

We employ prospect theory, an influential theory describing investors’ attitudes toward risk, to explain the effects of the unprecedented retail investor engagement and market performance in recent times. We find that prospect theory value (PTV) has strong predictive power for returns during retail trading booms, and this predictability is stronger for stocks with high investor attention and less subject to arbitrage forces. The retail wave during the COVID-19 pandemic propels PTV's predictive power in a way unseen in other historical crises. The high predictability of returns is attributable to attention-grabbing social media, fintech brokerage, investor sentiment, and government stimulus policy.