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This study analyzes the relationship between investor psychology and stock market behavior by investigating the over-reaction of stock prices based on the prospect theory. The main finding of this study is that the investor psychology is a cause of the stock price over-reaction, which can be explained by the prospect theory. The results of this study can be summarized as follows: First, the possibility of the price reversal of the abnormal performance portfolio is higher than that of the normal performance portfolio. The prospect theory says that people react more sensitively to higher probability changes. So investors perceive more sensitively to probability changes of past abnormal performance. Thus the over-reaction to abnormal performance occurs. Second, investors over-valuate the possibility of loss of stocks which have realized positive abnormal returns in the past, and then they become risk averse. Similarly, investors over-valuate the possibility of gain of stocks which have realized negative abnormal returns in the past, and they become less risk averse. As a result of these biased preferences, the psychological tendency of selling (or buying) of the past winner (or loser) abnormally increases. This psychological bias leads to price reversal and over-reaction. Third, the degree of over-reaction of the loser portfolio turned out to be larger than that of the winner portfolio. This can be explained by the implication of the prospect theory, which implies investors perceive negative utility from some amount of loss and positive utility from equivalent amount of gain. That is, the slope of the value function for loss is steeper than that of gain, which means investors react more sensitively to some loss than to the equal amount of gain.