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Computational aspects of prospect theory with asset pricing applications

Author

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  • Enrico Giorgi

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  • Thorsten Hens

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  • János Mayer

    ()

Abstract

We develop an algorithm to compute asset allocations for Kahneman and Tversky’s (Econometrica, 47(2), 263–291, 1979) prospect theory. An application to benchmark data as in Fama and French (Journal of Financial Economics, 47(2), 427–465, 1992) shows that the equity premium puzzle is resolved for parameter values similar to those found in the laboratory experiments of Kahneman and Tversky (Econometrica, 47(2), 263–291, 1979). While previous studies like Benartzi and Thaler (The Quarterly Journal of Economics, 110(1), 73–92, 1995), Barberis, Huang and Santos (The Quarterly Journal of Economics, 116(1), 1–53, 2001), and Grüne and Semmler (Asset prices and loss aversion, Germany, Mimeo Bielefeld University, 2005) focussed on dynamic aspects of asset pricing but only used loss aversion to explain the equity premium puzzle our paper explains the unconditional moments of asset pricing by a static two-period optimization problem. However, we incorporate asymmetric risk aversion. Our approach allows reducing the degree of loss aversion from 2.353 to 2.25, which is the value found by Tversky and Kahneman (Journal of Risk and Uncertainty, 5, 297–323, 1992) while increasing the risk aversion from 1 to 0.894, which is a slightly higher value than the 0.88 found by Tversky and Kahneman (Journal of Risk and Uncertainty, 5, 297–323, 1992). The equivalence of these parameter settings is robust to incorporating the size and the value portfolios of Fama and French (Journal of Finance, 47(2), 427–465, 1992). However, the optimal prospect theory portfolios found on this larger set of assets differ drastically from the optimal mean-variance portfolio. Copyright Springer Science+Business Media, LLC 2007

Suggested Citation

  • Enrico Giorgi & Thorsten Hens & János Mayer, 2007. "Computational aspects of prospect theory with asset pricing applications," Computational Economics, Springer;Society for Computational Economics, vol. 29(3), pages 267-281, May.
  • Handle: RePEc:kap:compec:v:29:y:2007:i:3:p:267-281
    DOI: 10.1007/s10614-006-9062-2
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    References listed on IDEAS

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    1. George Constantinides & John Donaldson & Rajnish Mehra, 2007. "Junior is rich: bequests as consumption," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 32(1), pages 125-155, July.
    2. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
    3. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    4. Shlomo Benartzi & Richard H. Thaler, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 73-92.
    5. Piazzesi, Monika & Schneider, Martin & Tuzel, Selale, 2007. "Housing, consumption and asset pricing," Journal of Financial Economics, Elsevier, vol. 83(3), pages 531-569, March.
    6. Willi Semmler & Lars Grüne, 2005. "Asset Pricing and Loss Aversion," Computing in Economics and Finance 2005 199, Society for Computational Economics.
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    8. Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 225-262, April.
    9. Martin Lettau, 2001. "Consumption, Aggregate Wealth, and Expected Stock Returns," Journal of Finance, American Finance Association, vol. 56(3), pages 815-849, June.
    10. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-543, June.
    11. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-1445, November.
    12. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-291, March.
    13. Rajnish Mehra, 2006. "The Equity Premium in India," NBER Working Papers 12434, National Bureau of Economic Research, Inc.
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    15. Nicholas Barberis & Ming Huang & Tano Santos, 2001. "Prospect Theory and Asset Prices," The Quarterly Journal of Economics, Oxford University Press, vol. 116(1), pages 1-53.
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    Citations

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    Cited by:

    1. Fortin, Ines & Hlouskova, Jaroslava, 2011. "Optimal asset allocation under linear loss aversion," Journal of Banking & Finance, Elsevier, vol. 35(11), pages 2974-2990, November.
    2. 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.
    3. Enrico Giorgi & Thorsten Hens, 2006. "Making prospect theory fit for finance," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 20(3), pages 339-360, September.
    4. Massimiliano Kaucic & Roberto Daris, 2016. "Prospect Theory Based Portfolio Optimization Problem with Imprecise Forecasts," Managing Global Transitions, University of Primorska, Faculty of Management Koper, vol. 14(4 (Winter), pages 359-384.
    5. De Giorgi, Enrico G. & Legg, Shane, 2012. "Dynamic portfolio choice and asset pricing with narrow framing and probability weighting," Journal of Economic Dynamics and Control, Elsevier, vol. 36(7), pages 951-972.
    6. repec:wsi:qjfxxx:v:07:y:2017:i:02:n:s201013921750001x is not listed on IDEAS
    7. Seyedehzahra NEMATOLLAHI & Giancarlo MANZI, 2018. "Portfolio Management Using Prospect Theory: Comparing Genetic Algorithms and Particle Swarm Optimization," Departmental Working Papers 2018-03, Department of Economics, Management and Quantitative Methods at Università degli Studi di Milano.
    8. Grauer, Robert R., 2013. "Limiting losses may be injurious to your wealth," Journal of Banking & Finance, Elsevier, vol. 37(12), pages 5088-5100.
    9. Michael Best & Robert Grauer & Jaroslava Hlouskova & Xili Zhang, 2014. "Loss-Aversion with Kinked Linear Utility Functions," Computational Economics, Springer;Society for Computational Economics, vol. 44(1), pages 45-65, June.

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