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Prospect Theory and Mean-Variance Analysis

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  • Haim Levy

Abstract

The experimental results of prospect theory (PT) reveal suggest that investors make decisions based on change of wealth rather than total wealth, that preferences are S-shaped with a risk-seeking segment, and that probabilities are subjectively distorted. This article shows that while PT's findings are in sharp contradiction to the foundations of mean-variance (MV) analysis, counterintuitively, when diversification between assets is allowed, the MV and PT-efficient sets almost coincide. Thus one can employ the MV optimization algorithm to construct PT-efficient portfolios. Copyright 2004, Oxford University Press.

Suggested Citation

  • Haim Levy, 2004. "Prospect Theory and Mean-Variance Analysis," The Review of Financial Studies, Society for Financial Studies, vol. 17(4), pages 1015-1041.
    • Handle: RePEc:oup:rfinst:v:17:y:2004:i:4:p:1015-1041
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