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Prospect theory, constant relative risk aversion, and the investment horizon

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  • Haim Levy
  • Moshe Levy

Abstract

Prospect Theory (PT) and Constant-Relative-Risk-Aversion (CRRA) preferences have clear-cut and very different implications for the optimal asset allocation between a riskless asset and a risky stock as a function of the investment horizon. While CRRA implies that the optimal allocation is independent of the horizon, we show that PT implies a dramatic and discontinuous “jump” in the optimal allocation as the horizon increases. We experimentally test these predictions at the individual level. We find rather strong support for CRRA, but very little support for PT.

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  • Haim Levy & Moshe Levy, 2021. "Prospect theory, constant relative risk aversion, and the investment horizon," PLOS ONE, Public Library of Science, vol. 16(4), pages 1-21, April.
    • Handle: RePEc:plo:pone00:0248904
    DOI: 10.1371/journal.pone.0248904
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    1. Butt, Adam & Khemka, Gaurav & Warren, Geoffrey J., 2022. "Heterogeneity in optimal investment and drawdown strategies in retirement," Pacific-Basin Finance Journal, Elsevier, vol. 74(C).
    2. Moshe Levy, 2022. "An evolutionary explanation of the Allais paradox," Journal of Evolutionary Economics, Springer, vol. 32(5), pages 1545-1574, November.

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