Portfolio Choice Under Cumulative Prospect Theory: An Analytical Treatment
AbstractWe formulate and carry out an analytical treatment of a single-period portfolio choice model featuring a reference point in wealth, S-shaped utility (value) functions with loss aversion, and probability weighting under Kahneman and Tversky's cumulative prospect theory (CPT). We introduce a new measure of loss aversion for large payoffs, called the large-loss aversion degree (LLAD), and show that it is a critical determinant of the well-posedness of the model. The sensitivity of the CPT value function with respect to the stock allocation is then investigated, which, as a by-product, demonstrates that this function is neither concave nor convex. We finally derive optimal solutions explicitly for the cases in which the reference point is the risk-free return and those in which it is not (while the utility function is piecewise linear), and we employ these results to investigate comparative statics of optimal risky exposures with respect to the reference point, the LLAD, and the curvature of the probability weighting. This paper was accepted by Wei Xiong, finance.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoArticle provided by INFORMS in its journal Management Science.
Volume (Year): 57 (2011)
Issue (Month): 2 (February)
portfolio choice; single period; cumulative prospect theory; reference point; loss aversion; S-shaped utility function; probability weighting; well-posedness;
You can help add them by filling out this form.
CitEc Project, subscribe to its RSS feed for this item.
- Liu, Shuangzhe & Ma, Tiefeng & Polasek, Wolfgang, 2012.
"Spatial System Estimators for Panel Models: A Sensitivity and Simulation Study,"
294, Institute for Advanced Studies.
- Shuangzhe Liu & Tiefeng Ma & Wolfgang Polasek, 2012. "Spatial System Estimators for Panel Models: A Sensitivity and Simulation Study," Working Paper Series 05_13, The Rimini Centre for Economic Analysis.
- Shuangzhe Liu & Tiefeng Ma & Wolfgang Polasek, 2012. "Spatial System Estimators for Panel Models: A Sensitivity and Simulation Study," Working Paper Series 75_12, The Rimini Centre for Economic Analysis.
- Miklos Rasonyi & Andrea M. Rodrigues, 2012. "Optimal Portfolio Choice for a Behavioural Investor in Continuous-Time Markets," Papers 1202.0628, arXiv.org, revised Apr 2013.
- Hlouskova, Jaroslava & Tsigaris, Panagiotis, 2012.
"Capital Income Taxation and Risk Taking under Prospect Theory,"
283, Institute for Advanced Studies.
- Jaroslava Hlouskova & Panagiotis Tsigaris, 2012. "Capital income taxation and risk taking under prospect theory," International Tax and Public Finance, Springer, vol. 19(4), pages 554-573, August.
- Hlouskova, Jaroslava & Tsigaris, Panagiotis, 2012. "What Does it Take for a Specific Prospect Theory Type Household to Engage in Risky Investment?," Economics Series 286, Institute for Advanced Studies.
- Ghossoub, Mario, 2011. "Towards a Purely Behavioral Definition of Loss Aversion," MPRA Paper 37628, University Library of Munich, Germany, revised 23 Mar 2012.
- Fortin, Ines & Hlouskova, Jaroslava, 2012. "Optimal Asset Allocation under Quadratic Loss Aversion," Economics Series 291, Institute for Advanced Studies.
- Matteo Del Vigna, 2011. "Financial market equilibria with heterogeneous agents: CAPM and market segmentation," DiMaD Working Papers 2011-08, Dipartimento di Matematica per le Decisioni, Universita' degli Studi di Firenze.
- De Giorgi, Enrico G. & Legg, Shane, 2012. "Dynamic portfolio choice and asset pricing with narrow framing and probability weighting," Journal of Economic Dynamics and Control, Elsevier, vol. 36(7), pages 951-972.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Mirko Janc).
If references are entirely missing, you can add them using this form.