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Continuous Cumulative Prospect Theory and Individual Asset Allocation

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Author Info
Davies, G.B.
Satchell, S.E.
Abstract

We implement the Cumulative Prospect Theory (CPT) framework (Tversky and Kahneman 1992) into a model of individual asset allocation, building on earlier work by Hwang and Satchell (2003) where they derive explicit formulae for the asset allocation decision using a loss aversion utility function. We apply Prelec’s probability weighting function (1998) to continuous distributions and derive the formulae for the optimal asset allocation between risky and safe assets. US equity returns data are used to examine the feasible parameter space. The earlier results of Hwang and Satchell are confirmed and the more complex model is compatible with observed equity proportions. The parameters are highly interconnected, but feasible combinations indicate that more inverse-S shaped deviations from linear probability weightings are associated with lower risk taking behaviour.

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Paper provided by Faculty of Economics, University of Cambridge in its series Cambridge Working Papers in Economics with number 0467.

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Length: 54
Date of creation: Nov 2004
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Handle: RePEc:cam:camdae:0467

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Keywords: Cumulative Prospect Theory; asset allocation; non-linear decisions weights;

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Find related papers by JEL classification:
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Ulrich Schmidt & Chris Starmer & Robert Sugden, 2008. "Third-generation prospect theory," Journal of Risk and Uncertainty, Springer, vol. 36(3), pages 203-223, June. [Downloadable!] (restricted)
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