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Prospect theory was proposed mainly to explain irrational investment behaviour. However, empirical evidence has come mostly from controlled experiments, and evidence from real data is rare. This paper uses panel data from a nationally representative survey in China to test whether prospect theory can explain stock market participation. The empirical results show that individuals take expected income as a reference point when investing in stocks. After real income and other factors are controlled for, the relative loss between expected and real income increases by 10,000 RMB, the probability of holding stocks increases by 0.77% and stock investment increases by 11.78%. The mechanism behind this is that relative losses motivate individuals to take excessive risks to hedge losses, while relative gains increase risk aversion and the holding of safe assets. These results can explain the puzzle of limited stock market participation. Participation costs are the main factor that restricts the low-income group from participating in the stock market, while the high-income group often faces relative gains, which leads to increased risk aversion and unwillingness to hold stocks.

Reference-dependent preferences and stock market participation