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Prospect Theory and Mean-Variance Analysis

Listed author(s):
  • Haim Levy
Registered author(s):

    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.

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    File URL: http://hdl.handle.net/10.1093/rfs/hhg062
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    Article provided by Society for Financial Studies in its journal The Review of Financial Studies.

    Volume (Year): 17 (2004)
    Issue (Month): 4 ()
    Pages: 1015-1041

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    Handle: RePEc:oup:rfinst:v:17:y:2004:i:4:p:1015-1041
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    1. 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.
    2. Fred D. Arditti, 1967. "Risk And The Required Return On Equity," Journal of Finance, American Finance Association, vol. 22(1), pages 19-36, March.
    3. Tversky, Amos & Kahneman, Daniel, 1992. "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
    4. Harless, David W & Camerer, Colin F, 1994. "The Predictive Utility of Generalized Expected Utility Theories," Econometrica, Econometric Society, vol. 62(6), pages 1251-1289, November.
    5. Camerer, Colin F & Ho, Teck-Hua, 1994. "Violations of the Betweenness Axiom and Nonlinearity in Probability," Journal of Risk and Uncertainty, Springer, vol. 8(2), pages 167-196, March.
    6. Jeff T. Casey, 1994. "Buyers' Pricing Behavior for Risky Alternatives: Encoding Processes and Preference Reversals," Management Science, INFORMS, vol. 40(6), pages 730-749, June.
    7. Rubinstein, Mark E., 1973. "The Fundamental Theorem of Parameter-Preference Security Valuation," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 8(01), pages 61-69, January.
    8. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
    9. Moshe Levy & Haim Levy, 2002. "Prospect Theory: Much Ado About Nothing?," Management Science, INFORMS, vol. 48(10), pages 1334-1349, October.
    10. William J. Baumol, 1963. "An Expected Gain-Confidence Limit Criterion for Portfolio Selection," Management Science, INFORMS, vol. 10(1), pages 174-182, October.
    11. Merton, Robert C., 1972. "An Analytic Derivation of the Efficient Portfolio Frontier," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 7(04), pages 1851-1872, September.
    12. Battalio, Raymond C & Kagel, John H & Jiranyakul, Komain, 1990. "Testing between Alternative Models of Choice under Uncertainty: Some Initial Results," Journal of Risk and Uncertainty, Springer, vol. 3(1), pages 25-50, March.
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