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Goal-Based Investing with Cumulative Prospect Theory and Satisficing Behavior

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Author Info
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://www.vwa.unisg.ch/RePEc/usg/dp2009/DP-22-Gi.pdf
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Publisher 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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Find related papers by JEL classification:
D10 - Microeconomics - - Household Behavior - - - General
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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References listed on IDEAS
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  1. Nicholas Barberis, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," Journal of Finance, American Finance Association, vol. 56(4), pages 1247-1292, 08. [Downloadable!] (restricted)
  2. 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. [Downloadable!] (restricted)
  3. Benartzi, Shlomo & Thaler, Richard H, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, MIT Press, vol. 110(1), pages 73-92, February. [Downloadable!] (restricted)
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  4. Nicholas Barberis & Ming Huang, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," NBER Working Papers 8190, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  5. Nishant Dass & Massimo Massa & Rajdeep Patgiri, 2008. "Mutual Funds and Bubbles: The Surprising Role of Contractual Incentives," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 21(1), pages 51-99, January. [Downloadable!] (restricted)
  6. Hanqing Jin & Xun Yu Zhou, 2008. "Behavioral Portfolio Selection In Continuous Time," Mathematical Finance, Blackwell Publishing, vol. 18(3), pages 385-426. [Downloadable!] (restricted)
  7. 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. [Downloadable!] (restricted)
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  8. 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:
  9. 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. [Downloadable!]
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