IDEAS home Printed from https://ideas.repec.org/a/bla/eufman/v18y2012i2p163-182.html
   My bibliography  Save this article

Two Paradigms and Nobel Prizes in Economics: a Contradiction or Coexistence?

Author

Listed:
  • Haim Levy
  • Enrico G. De Giorgi
  • Thorsten Hens

Abstract

  Markowitz and Sharpe won the Nobel Prize in Economics for the development of Mean†Variance (M†V) analysis and the Capital Asset Pricing Model (CAPM). Kahneman won the Nobel Prize in Economics for the development of Prospect Theory. In deriving the CAPM, Sharpe, Lintner and Mossin assume expected utility (EU) maximisation in the face of risk aversion. Kahneman and Tversky suggest Prospect Theory (PT) as an alternative paradigm to EU theory. They show that investors distort probabilities, make decisions based on change of wealth, exhibit loss aversion and maximise the expectation of an S†shaped value function, which contains a risk†seeking segment. Can these two apparently contradictory paradigms coexist? We show in this paper that although CPT (and PT) is in conflict to EUT, and violates some of the CAPM's underlying assumptions, the Security Market Line Theorem (SMLT) of the CAPM is intact in the CPT framework. Therefore, the CAPM is intact also in CPT framework.

Suggested Citation

  • Haim Levy & Enrico G. De Giorgi & Thorsten Hens, 2012. "Two Paradigms and Nobel Prizes in Economics: a Contradiction or Coexistence?," European Financial Management, European Financial Management Association, vol. 18(2), pages 163-182, March.
    • Handle: RePEc:bla:eufman:v:18:y:2012:i:2:p:163-182
    DOI: 10.1111/j.1468-036X.2011.00617.x
    as

    Download full text from publisher

    File URL: https://doi.org/10.1111/j.1468-036X.2011.00617.x
    Download Restriction: no
    File URL: https://libkey.io/10.1111/j.1468-036X.2011.00617.x?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    References listed on IDEAS

    as
    1. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-887, September.
    2. Ross, Stephen A, 1977. "The Capital Asset Pricing Model (CAPM), Short-Sale Restrictions and Related Issues," Journal of Finance, American Finance Association, vol. 32(1), pages 177-183, March.
    3. Jagannathan, Ravi & Wang, Zhenyu, 1996. "The Conditional CAPM and the Cross-Section of Expected Returns," Journal of Finance, American Finance Association, vol. 51(1), pages 3-53, March.
    4. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    5. John Lintner, 1965. "Security Prices, Risk, And Maximal Gains From Diversification," Journal of Finance, American Finance Association, vol. 20(4), pages 587-615, December.
    6. Sharpe, William F, 1991. "Capital Asset Prices with and without Negative Holdings," Journal of Finance, American Finance Association, vol. 46(2), pages 489-509, June.
    7. Yaari, Menahem E, 1987. "The Dual Theory of Choice under Risk," Econometrica, Econometric Society, vol. 55(1), pages 95-115, January.
    8. Shlomo Benartzi & Richard H. Thaler, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 110(1), pages 73-92.
    9. Haim Levy & Paul A. Samuelson, 1992. "The Capital Asset Pricing Model with Diverse Holding Periods," Management Science, INFORMS, vol. 38(11), pages 1529-1542, November.
    10. Daniel Kahneman & Amos Tversky, 2013. "Prospect Theory: An Analysis of Decision Under Risk," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 6, pages 99-127, World Scientific Publishing Co. Pte. Ltd..
    11. Haim Levy, 1992. "Stochastic Dominance and Expected Utility: Survey and Analysis," Management Science, INFORMS, vol. 38(4), pages 555-593, April.
    12. Tversky, Amos & Kahneman, Daniel, 1992. "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
    13. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
    14. Berk, Jonathan B., 1997. "Necessary Conditions for the CAPM," Journal of Economic Theory, Elsevier, vol. 73(1), pages 245-257, March.
    15. G. Hanoch & H. Levy, 1969. "The Efficiency Analysis of Choices Involving Risk," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 36(3), pages 335-346.
    16. Roll, Richard, 1977. "A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory," Journal of Financial Economics, Elsevier, vol. 4(2), pages 129-176, March.
    17. Levy, Haim, 1997. "Risk and Return: An Experimental Analysis," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 38(1), pages 119-149, February.
    18. Merton, Robert C, 1987. "A Simple Model of Capital Market Equilibrium with Incomplete Information," Journal of Finance, American Finance Association, vol. 42(3), pages 483-510, July.
    19. Handa, Jagdish, 1977. "Risk, Probabilities, and a New Theory of Cardinal Utility," Journal of Political Economy, University of Chicago Press, vol. 85(1), pages 97-122, February.
    20. Nicholas Barberis & Ming Huang, 2008. "Stocks as Lotteries: The Implications of Probability Weighting for Security Prices," American Economic Review, American Economic Association, vol. 98(5), pages 2066-2100, December.
    21. Moshe Levy & Richard Roll, 2010. "The Market Portfolio May Be Mean/Variance Efficient After All," Review of Financial Studies, Society for Financial Studies, vol. 23(6), pages 2464-2491, June.
    22. Haim Levy, 1991. "Note---The Mean-Coefficient-of-Variation Rule: The Lognormal Case," Management Science, INFORMS, vol. 37(6), pages 745-747, June.
    23. Levy, Haim, 1973. "Stochastic Dominance Among Log-Normal Prospects," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 14(3), pages 601-614, October.
    24. Shefrin, Hersh & Statman, Meir, 1985. "The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence," Journal of Finance, American Finance Association, vol. 40(3), pages 777-790, July.
    25. Quiggin, John, 1982. "A theory of anticipated utility," Journal of Economic Behavior & Organization, Elsevier, vol. 3(4), pages 323-343, December.
    26. Haim Levy, 2010. "The CAPM is Alive and Well: A Review and Synthesis," European Financial Management, European Financial Management Association, vol. 16(1), pages 43-71, January.
    27. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-636, May-June.
    28. Levy, Haim & Wiener, Zvi, 1998. "Stochastic Dominance and Prospect Dominance with Subjective Weighting Functions," Journal of Risk and Uncertainty, Springer, vol. 16(2), pages 147-163, May-June.
    29. Markowitz, Harry M, 1991. "Foundations of Portfolio Theory," Journal of Finance, American Finance Association, vol. 46(2), pages 469-477, June.
    30. Hadar, Josef & Russell, William R, 1969. "Rules for Ordering Uncertain Prospects," American Economic Review, American Economic Association, vol. 59(1), pages 25-34, March.
    31. Levy, H & Markowtiz, H M, 1979. "Approximating Expected Utility by a Function of Mean and Variance," American Economic Review, American Economic Association, vol. 69(3), pages 308-317, June.
    32. Terrance Odean, 1998. "Are Investors Reluctant to Realize Their Losses?," Journal of Finance, American Finance Association, vol. 53(5), pages 1775-1798, October.
    33. Levy, Haim, 1978. "Equilibrium in an Imperfect Market: A Constraint on the Number of Securities in the Portfolio," American Economic Review, American Economic Association, vol. 68(4), pages 643-658, September.
    34. Black, Fischer, 1972. "Capital Market Equilibrium with Restricted Borrowing," The Journal of Business, University of Chicago Press, vol. 45(3), pages 444-455, July.
    35. Haim Levy, 2004. "Prospect Theory and Mean-Variance Analysis," Review of Financial Studies, Society for Financial Studies, vol. 17(4), pages 1015-1041.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Maxime MERLI & Antoine PARENT, 2022. "Portfolio Diversification During the Belle Époque: When the Actual Portfolios of French Individual Investors Met Behavioral Finance," Working Papers of LaRGE Research Center 2022-01, Laboratoire de Recherche en Gestion et Economie (LaRGE), Université de Strasbourg.
    2. Pfiffelmann, Marie & Roger, Tristan & Bourachnikova, Olga, 2016. "When Behavioral Portfolio Theory meets Markowitz theory," Economic Modelling, Elsevier, vol. 53(C), pages 419-435.
    3. Levy, Moshe, 2022. "An inter-temporal CAPM based on First order Stochastic Dominance," European Journal of Operational Research, Elsevier, vol. 298(2), pages 734-739.
    4. Rabah Amir & Sergei Belkov & Igor V. Evstigneev & Thorsten Hens, 2022. "An evolutionary finance model with short selling and endogenous asset supply," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 73(2), pages 655-677, April.
    5. Levy, Moshe & Levy, Haim, 2015. "Keeping up with the Joneses and optimal diversification," Journal of Banking & Finance, Elsevier, vol. 58(C), pages 29-38.
    6. Amen Aissi Harzallah & Mouna Boujelbene Abbes, 2020. "The Impact of Financial Crises on the Asset Allocation: Classical Theory Versus Behavioral Theory," Journal of Interdisciplinary Economics, , vol. 32(2), pages 218-236, July.
    7. Matteo Del Vigna, 2012. "Stochastic dominance for law invariant preferences: The happy story of elliptical distributions," Working Papers - Mathematical Economics 2012-08, Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa.
    8. Nicholas Apergis & James E. Payne, 2018. "Monetary policy rules and the equity risk premium: Evidence from the US experience," Review of Financial Economics, John Wiley & Sons, vol. 36(4), pages 287-299, October.
    9. Haim Levy & Moshe Levy, 2021. "Prospect theory, constant relative risk aversion, and the investment horizon," PLOS ONE, Public Library of Science, vol. 16(4), pages 1-21, April.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Levy, Haim & Levy, Moshe, 2002. "Experimental test of the prospect theory value function: A stochastic dominance approach," Organizational Behavior and Human Decision Processes, Elsevier, vol. 89(2), pages 1058-1081, November.
    2. Haim Levy, 2010. "The CAPM is Alive and Well: A Review and Synthesis," European Financial Management, European Financial Management Association, vol. 16(1), pages 43-71, January.
    3. Levy, Moshe & Levy, Haim, 2015. "Keeping up with the Joneses and optimal diversification," Journal of Banking & Finance, Elsevier, vol. 58(C), pages 29-38.
    4. Arvanitis, Stelios & Scaillet, Olivier & Topaloglou, Nikolas, 2020. "Spanning analysis of stock market anomalies under prospect stochastic dominance," Working Papers unige:134101, University of Geneva, Geneva School of Economics and Management.
    5. Moshe Levy & Haim Levy, 2013. "Prospect Theory: Much Ado About Nothing?," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 7, pages 129-144, World Scientific Publishing Co. Pte. Ltd..
    6. John Y. Campbell, 2000. "Asset Pricing at the Millennium," Journal of Finance, American Finance Association, vol. 55(4), pages 1515-1567, August.
    7. Sonntag, Dominik, 2018. "Die Theorie der fairen geometrischen Rendite [The Theory of Fair Geometric Returns]," MPRA Paper 87082, University Library of Munich, Germany.
    8. Thierry Post & Haim Levy, 2002. "Does Risk Seeking drive Asset Prices?," Tinbergen Institute Discussion Papers 02-070/2, Tinbergen Institute.
    9. Post, G.T. & Levy, H., 2002. "Does Risk Seeking Drive Asset Prices? A stochastic dominance analysis of aggregate investor preferences," ERIM Report Series Research in Management ERS-2002-50-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam.
    10. Levy, Haim & Wiener, Zvi, 2013. "Prospect theory and utility theory: Temporary versus permanent attitude toward risk," Journal of Economics and Business, Elsevier, vol. 68(C), pages 1-23.
    11. Adam Zaremba & Jacob Koby Shemer, 2018. "Price-Based Investment Strategies," Springer Books, Springer, number 978-3-319-91530-2, June.
    12. Levy, Moshe, 2022. "An inter-temporal CAPM based on First order Stochastic Dominance," European Journal of Operational Research, Elsevier, vol. 298(2), pages 734-739.
    13. Wang, Huijun & Yan, Jinghua & Yu, Jianfeng, 2017. "Reference-dependent preferences and the risk–return trade-off," Journal of Financial Economics, Elsevier, vol. 123(2), pages 395-414.
    14. Amit Goyal, 2012. "Empirical cross-sectional asset pricing: a survey," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 26(1), pages 3-38, March.
    15. Levy, Haim & Levy, Moshe, 2021. "Stocks versus bonds for the long run when a riskless asset is available," Journal of Banking & Finance, Elsevier, vol. 133(C).
    16. Trabelsi, Mohamed Ali, 2006. "Les nouveaux modèles de décision dans le risque et l’incertain : quel apport ? [The new models of decision under risk or uncertainty : What approach?]," MPRA Paper 25442, University Library of Munich, Germany.
    17. Haim Levy, 2017. "What is the Economic Cost of the Investment Home Bias?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 49(5), pages 897-929, August.
    18. Matteo Del Vigna, 2011. "Financial market equilibria with heterogeneous agents: CAPM and market segmentation," Working Papers - Mathematical Economics 2011-08, Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa.
    19. Jakusch, Sven Thorsten, 2017. "On the applicability of maximum likelihood methods: From experimental to financial data," SAFE Working Paper Series 148, Leibniz Institute for Financial Research SAFE, revised 2017.
    20. Wing-Keung Wong & Chenghu Ma, 2008. "Preferences over location-scale family," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 37(1), pages 119-146, October.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:bla:eufman:v:18:y:2012:i:2:p:163-182. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Wiley Content Delivery (email available below). General contact details of provider: https://edirc.repec.org/data/efmaaea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.