Abstract
Motivated by Kahneman and Tversky (1979) and Yuan (2015), this paper investigates whether the influence of the historical high ratio on subsequent stock index returns varies with the distance of the current stock index from its historical high. To explore this issue, a regression kink model with an unknown threshold proposed by Hansen (2017) is used for analysis. Using data from visible stock indices for G7 countries, our empirical evidence shows the presence of threshold effects for most of the G7 stock indices. Moreover, the evidence indicates that the historical high ratio has a strong negative effect on subsequent stock index returns, as the current stock index price is far from its historical high. Overall, these findings support the prospect theory developed by Kahneman and Tversky (1979), in that investors are instinctively risk-seeking (averse) when they face a loss (gain).
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