Efficiency Evaluation of Assets and Optimal Portfolio Generation by Cross Efficiency and Cumulative Prospect Theory

The paper proposes a portfolio selection approach based on cumulative prospect theory (CPT) that integrates data envelopment analysis (DEA). The CPT-based model has emerged as the best model in behavioral portfolio theory for incorporating decision-maker behavior in risk and uncertainty. We are using the quadratic value function suggested in the study of Gazioğlu and Çalışkan (Appl Financ Econom 21(21):1581–1586, 2011), which is the best alternative to the value function proposed by Kahneman and Tversky (Handbook of the fundamentals of financial decision making: Part I, World Scientific, 2013) in the literature. Based on the CPT value of each asset, we bifurcate the assets into two groups, top CPT value assets and bottom CPT value assets. To assess the cross-efficiency of the assets, we consider the CPT value and long-term return of each asset as outputs and the variance of the return as an input. We combine cumulative prospect theory with cross-efficiency and examine the psychological aspects of decision-makers in portfolio selection. The study used thirty listed stocks from the Nifty-50, the National Stock Exchange, India for empirical investigation. The empirical findings elucidate that the portfolios generated by the highest CPT value surpass those generated by the lowest CPT value. We demonstrate that the proposed approach can be a potential tool for portfolio selection by exhibiting that the selected portfolio delivers greater risk-adjusted returns in the financial markets.