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Goal-Based Investing with Cumulative Prospect Theory and Satisficing Behavior

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  • Enrico G. De Giorgi

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Abstract

This paper presents a time-continuous goal-based portfolio selection model with cumulative prospect theory preferences and satisficing behavior, where investors optimally split their wealth among several investment goals at different horizons. The paper extends the model of Berkelaar, Kouwenberg and Post (2004) to account for multiple-goals. We show that when the discounted values of all target wealths is not too high relative to the initial wealth (i.e., goals are not too ambitious), investors mainly invest to reach short-term investment goals and adopt safe investment strategies for this purpose. However, when goals are very ambitious, they put a high proportion of their wealth in long-term goals and adopt aggressive investment strategies with high leverage to reach short-term goals and the overall investment strategy also displays high leverage. High incentives to reach ambitious shortterm goals (high target returns) and the consequent excessive leverage have been identified as causes for the global financial crisis erupted in 2008.

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File URL: http://www1.vwa.unisg.ch/RePEc/usg/dp2009/DP-0922-Gi.pdf
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Bibliographic Info

Paper provided by Department of Economics, University of St. Gallen in its series University of St. Gallen Department of Economics working paper series 2009 with number 2009-22.

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Length: 51 pages
Date of creation: Aug 2009
Date of revision:
Handle: RePEc:usg:dp2009:2009-22

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Related research

Keywords: behavioral finance; portfolio selection; mental accounting; narrow framing; cumulative prospect theory; satisficing; loss aversion; goal-based approach;

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  1. David B. Brown & Melvyn Sim, 2009. "Satisficing Measures for Analysis of Risky Positions," Management Science, INFORMS, vol. 55(1), pages 71-84, January.
  2. Shlomo Benartzi & Richard H. Thaler, 1993. "Myopic Loss Aversion and the Equity Premium Puzzle," NBER Working Papers 4369, National Bureau of Economic Research, Inc.
  3. Mankiw, N. Gregory & Zeldes, Stephen P., 1991. "The consumption of stockholders and nonstockholders," Journal of Financial Economics, Elsevier, vol. 29(1), pages 97-112, March.
  4. 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.
  5. David B. BROWN & Enrico G. DE GIORGI & Melvyn SIM, . "A Satiscing Alternative to Prospect Theory," Swiss Finance Institute Research Paper Series 09-19, Swiss Finance Institute.
  6. 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, November.
  7. 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.
  8. Richard Thaler, 1985. "Mental Accounting and Consumer Choice," Marketing Science, INFORMS, vol. 4(3), pages 199-214.
  9. Nicholas Barberis, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," Journal of Finance, American Finance Association, vol. 56(4), pages 1247-1292, 08.
  10. Enrico G. De Giorgi & Shane Legg, 2009. "Portfolio Selection with Narrow Framing: Probability Weighting Matters," University of St. Gallen Department of Economics working paper series 2009 2009-12, Department of Economics, University of St. Gallen.
  11. Brad M. Barber & Terrance Odean, 2000. "Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors," Journal of Finance, American Finance Association, vol. 55(2), pages 773-806, 04.
  12. Nicholas Barberis & Ming Huang, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," NBER Working Papers 8190, National Bureau of Economic Research, Inc.
  13. Shefrin, Hersh & Statman, Meir, 2000. "Behavioral Portfolio Theory," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(02), pages 127-151, June.
  14. Nishant Dass & Massimo Massa & Rajdeep Patgiri, 2008. "Mutual Funds and Bubbles: The Surprising Role of Contractual Incentives," Review of Financial Studies, Society for Financial Studies, vol. 21(1), pages 51-99, January.
  15. Hanqing Jin & Xun Yu Zhou, 2008. "Behavioral Portfolio Selection In Continuous Time," Mathematical Finance, Wiley Blackwell, vol. 18(3), pages 385-426.
  16. Das, Sanjiv & Markowitz, Harry & Scheid, Jonathan & Statman, Meir, 2010. "Portfolio Optimization with Mental Accounts," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 45(02), pages 311-334, April.
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