Behavioral Asset Pricing Model Based on Regret Theory

Regret theory is a behavioral approach to decision making under uncertain environment. We assume there are only two representative investors, a representative passive investor and a representative active investor in a frictionless market. This paper considers the equilibrium effects of the representative active investor who selects his own optimal portfolio based on regret theory and the representative passive investor only invests on benchmark portfolio. In a partial equilibrium setting, the objective of the representative active is modeled as the minimization of regret of final wealth to benchmark portfolio. In equilibrium this optimal strategy gives rise to a behavioral asset pricing model. There are two betas in the asset pricing model, the market beta and a new risk-factor. This new beta is defined as the normalized (to the benchmark's variance) covariance between the asset excess return and excess return of the market over the benchmark portfolio. Also the coefficient of absolute risk aversion and regret aversion of representative investor are the pricing variable under regret theory. We extend our model to multi-benchmark portfolio. Unfortunately the empirical test do not supports the model's predictions with the stock data of China.