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Prospect Theory and Mean-Variance Analysis

In: HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I

Author

Listed:
  • Haim Levy
  • Moshe 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 preference 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 PTefficient portfolios…

Suggested Citation

  • Haim Levy & Moshe Levy, 2013. "Prospect Theory and Mean-Variance Analysis," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 9, pages 149-175, World Scientific Publishing Co. Pte. Ltd..
  • Handle: RePEc:wsi:wschap:9789814417358_0009
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