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Making Prospect Theory Fit for Finance

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Author Info
De Giorgi, Enrico () (Institute of Finance, University of Lugano)
Hens, Thorsten () (Institute for Empirical Research in Economics, University of Zurich)

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Abstract

This paper gives a survey over a common aspect of prospect theory that occurred to be of importance in a series of recent papers developed by Enrico De Giorgi, Thorsten Hens, Janos Mayer, Haim Levy, Thierry Post, Marc Oliver Rieger and Mei Wang. The common aspect of these papers is that the value function of the prospect theory of Kahneman and Tversky (1979) and similarly that of Tversky and Kahneman (1992) has to be re-modelled if one wants to apply it to portfolio selection. Instead of the piecewise power value function, a piecewise negative exponential function should be used. This functional form is still compatible with laboratory experiments but it has the following advantages over and above Kahneman and Tversky`s piecewise power function:

1. The Bernoulli Paradox does not arise for lotteries with finite expected value.

2. No infinite leverage/robustness problem arises.

3. CAPM-equilibria with heterogeneous investors and prospect utility do exist.

4. It is able to simultaneously resolve the following asset pricing puzzles: the equity premium, the value and the size puzzle.

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Publisher Info
Paper provided by Department of Finance and Management Science, Norwegian School of Economics and Business Administration in its series Discussion Papers with number 2005/19.

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Length: 18 pages
Date of creation: 22 Dec 2005
Date of revision:
Handle: RePEc:hhs:nhhfms:2005_019

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Postal: NHH, Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway
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Web page: http://www.nhh.no/for/
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Related research
Keywords: Prospect theory; portfolio selection;

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Find related papers by JEL classification:
G00 - Financial Economics - - General - - - General

This paper has been announced in the following NEP Reports:

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.:
  1. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-65, June. [Downloadable!] (restricted)
  2. Basu, S, 1977. "Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis," Journal of Finance, American Finance Association, vol. 32(3), pages 663-82, June. [Downloadable!] (restricted)
  3. Hens, Thorsten & Vlcek, Martin, 2005. "Does Prospect Theory Explain the Disposition Effect?," Discussion Papers 2005/18, Department of Finance and Management Science, Norwegian School of Economics and Business Administration. [Downloadable!]
  4. 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 777-90, July. [Downloadable!] (restricted)
  5. Shlomo Benartzi & Richard H. Thaler, 1993. "Myopic Loss Aversion and the Equity Premium Puzzle," NBER Working Papers 4369, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  6. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November. [Downloadable!] (restricted)
  7. Nicholas Barberis & Ming Huang & Tano Santos, 2001. "Prospect Theory And Asset Prices," The Quarterly Journal of Economics, MIT Press, vol. 116(1), pages 1-53, February. [Downloadable!] (restricted)
  8. Enrico Giorgi & Thorsten Hens & János Mayer, 2007. "Computational aspects of prospect theory with asset pricing applications," Computational Economics, Springer, vol. 29(3), pages 267-281, May. [Downloadable!] (restricted)
  9. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February. [Downloadable!] (restricted)
  10. 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.
  11. Terrance Odean, 1998. "Are Investors Reluctant to Realize Their Losses?," Journal of Finance, American Finance Association, vol. 53(5), pages 1775-1798, October. [Downloadable!] (restricted)
  12. De Giorgi, Enrico & Hens, Thorsten & Post, Thierry, 2005. "Prospect Theory and the Size and Value Premium Puzzles," Discussion Papers 2005/20, Department of Finance and Management Science, Norwegian School of Economics and Business Administration. [Downloadable!]
  13. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March. [Downloadable!] (restricted)
  14. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August. [Downloadable!] (restricted)
  15. Banz, Rolf W., 1981. "The relationship between return and market value of common stocks," Journal of Financial Economics, Elsevier, vol. 9(1), pages 3-18, March. [Downloadable!] (restricted)
  16. Arjan B. Berkelaar & Roy Kouwenberg & Thierry Post, 2004. "Optimal Portfolio Choice under Loss Aversion," The Review of Economics and Statistics, MIT Press, vol. 86(4), pages 973-987, 02. [Downloadable!] (restricted)
    Other versions:
  17. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March. [Downloadable!] (restricted)
  18. Weber, Martin & Camerer, Colin F., 1998. "The disposition effect in securities trading: an experimental analysis," Journal of Economic Behavior & Organization, Elsevier, vol. 33(2), pages 167-184, January. [Downloadable!] (restricted)
Full references

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. Marie-Hélène Broihanne & Maxime Merli & Patrick Roger, 2008. "A Behavioural Approach To Financial Puzzles," Working Papers of LaRGE (Laboratoire de Recherche en Gestion et Economie) 2008-01, Laboratoire de Recherche en Gestion et Economie, Université de Strasbourg (France). [Downloadable!]
  2. Bernard, Carole & Ghossoub, Mario, 2009. "Static Portfolio Choice under Cumulative Prospect Theory," MPRA Paper 15446, University Library of Munich, Germany, revised 29 Apr 2009. [Downloadable!]
  3. André Gygax & Anna Griffiths, 2007. "Do venture capitalists imitate portfolio size?," Financial Markets and Portfolio Management, Springer, vol. 21(1), pages 69-94, March. [Downloadable!] (restricted)
  4. Trond Døskeland, 2007. "Strategic asset allocation for a country: the Norwegian case," Financial Markets and Portfolio Management, Springer, vol. 21(2), pages 167-201, June. [Downloadable!] (restricted)
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