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Prospect theory and portfolio selection

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  • Best, Michael J.
  • Grauer, Robert R.

Abstract

We examine prospect theory portfolios in asset allocation settings that include riskfree lending and borrowing, subject to margin constraints, and short sales restrictions on risky assets. In static settings, we focus on myopic loss aversion, which assumes loss averse investors are willing to take more risk if they evaluate their investment performance infrequently. The results show the portfolios, including those of the investor with a loss aversion coefficient of 2.25, are extremely unstable across decision horizons. In dynamic settings, the portfolios of investors with loss aversion on the order of two perform well. But in some instances the house money effect, where the position of the kink and the investor’s loss aversion changes with gains and losses, has a large negative impact on the wealth of these investors.

Suggested Citation

  • Best, Michael J. & Grauer, Robert R., 2016. "Prospect theory and portfolio selection," Journal of Behavioral and Experimental Finance, Elsevier, vol. 11(C), pages 13-17.
    • Handle: RePEc:eee:beexfi:v:11:y:2016:i:c:p:13-17
    DOI: 10.1016/j.jbef.2016.05.002
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    Citations

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    Cited by:

    1. Kumar, Satish & Rao, Sandeep & Goyal, Kirti & Goyal, Nisha, 2022. "Journal of Behavioral and Experimental Finance: A bibliometric overview," Journal of Behavioral and Experimental Finance, Elsevier, vol. 34(C).
    2. Masoud Rahiminezhad Galankashi & Farimah Mokhatab Rafiei & Maryam Ghezelbash, 2020. "Portfolio selection: a fuzzy-ANP approach," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 6(1), pages 1-34, December.
    3. Michael J. Best & Robert R. Grauer, 2017. "Humans, Econs and Portfolio Choice," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 7(02), pages 1-30, June.
    4. Zhang, Cheng & Gong, Xiaomin & Zhang, Jingshu & Chen, Zhiwei, 2023. "Dynamic portfolio allocation for financial markets: A perspective of competitive-cum-compensatory strategy," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 84(C).
    5. Zsurkis, Gabriel & Nicolau, João & Rodrigues, Paulo M.M., 2024. "First passage times in portfolio optimization: A novel nonparametric approach," European Journal of Operational Research, Elsevier, vol. 312(3), pages 1074-1085.
    6. Giannikos, Christos I. & Kakolyris, Andreas & Suen, Tin Shan, 2023. "Prospect theory and a manager's decision to trade a blind principal bid basket," Global Finance Journal, Elsevier, vol. 55(C).
    7. Yousra Trichilli & Hana Kharrat & Mouna Boujelbène Abbes, 2021. "Prospect theory and risk-taking behavior: an empirical investigation of Islamic and conventional banks," Journal of Asset Management, Palgrave Macmillan, vol. 22(3), pages 163-178, May.
    8. Stephen Bahadar & Muhammad Nadeem & Rashid Zaman, 2023. "Toxic chemical releases and idiosyncratic return volatility: A prospect theory perspective," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 63(2), pages 2109-2143, June.
    9. Xin Yao & Hai-xiang Guo & Jian Zhu & Yong Shi, 2022. "Dynamic selection of emergency plans of geological disaster based on case-based reasoning and prospect theory," Natural Hazards: Journal of the International Society for the Prevention and Mitigation of Natural Hazards, Springer;International Society for the Prevention and Mitigation of Natural Hazards, vol. 110(3), pages 2249-2275, February.

    More about this item

    Keywords

    Portfolio choice; Prospect theory; Kinked linear utility;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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