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Performance Measurement with Loss Aversion

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  • Mark Salmon
  • Soosung Hwang
  • Gordon Gemmill

Abstract

We examine a simple measure of portfolio performance based on prospect theory, which captures not only risk and return but also reflects differential aversion to upside and downside risk. The measure we propose is a ratio of gains to losses, with the gains and losses weighted (if desired) to reflect risk-aversion for gains and risk-seeking for losses. It can also be interpreted as the weighted ratio of the value of a call option to a put option, with the benchmark as the exercise price. When applying the loss-aversion performance measure to closed-end funds, we find that it gives significantly different rankings from those of conventional measures (such as the Sharpe ratio, Jensen's alpha, the Sortino ratio, and the Higher Moment measure), and gives the expected signs for the odd and even moments of tracking errors. However, loss-aversion performance is not more closely related to discounts on funds than are the conventional performance measures, so we have not found evidence that loss-aversion attracts investors to particular funds in the short-term.

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Paper provided by Warwick Business School, Finance Group in its series Working Papers with number wp05-08.

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Date of creation: 2005
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Handle: RePEc:wbs:wpaper:wp05-08

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  4. Shlomo Benartzi & Richard H. Thaler, 1993. "Myopic Loss Aversion and the Equity Premium Puzzle," NBER Working Papers 4369, National Bureau of Economic Research, Inc.
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  17. Richard H. Thaler & Eric J. Johnson, 1990. "Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice," Management Science, INFORMS, vol. 36(6), pages 643-660, June.
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  20. Connor, Gregory & Korajczyk, Robert A., 1986. "Performance measurement with the arbitrage pricing theory : A new framework for analysis," Journal of Financial Economics, Elsevier, vol. 15(3), pages 373-394, March.
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