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Investors Facing Risk: Prospect Theory and Non-Expected Utility in Portfolio Selection

Author

Listed:
  • Erick W. Rengifo

    (Fordham University)

  • Debra Emanuela Trifan

    (Bayerngas Energy)

  • Debra Rossen Trendafilov

    (Truman State University)

Abstract

This paper focuses on the attitude of non-professional investors towards financial losses and their decisions on wealth allocation, and how these change subject to behavioral factors. Our contribution concerns the integration of behavioral elements into the classic portfolio optimization. Individual perceptions are modeled according to an extended prospect-theory framework: Losses loom larger than gains of the same size (loss aversion) and the past riskyportfolio performance changes the subjective valuation of risky investments. The utility of financial investments is overemphasized (myopia). The portfolio model with individual VaR delivers an optimal wealth assignment between risky and risk-free assets.

Suggested Citation

  • Erick W. Rengifo & Debra Emanuela Trifan & Debra Rossen Trendafilov, 2014. "Investors Facing Risk: Prospect Theory and Non-Expected Utility in Portfolio Selection," Fordham Economics Discussion Paper Series dp2014-03, Fordham University, Department of Economics.
    • Handle: RePEc:frd:wpaper:dp2014-03
    as

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    References listed on IDEAS

    as
    1. 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.
    2. Shlomo Benartzi & Richard H. Thaler, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 110(1), pages 73-92.
    3. Campbell, Rachel & Huisman, Ronald & Koedijk, Kees, 2001. "Optimal portfolio selection in a Value-at-Risk framework," Journal of Banking & Finance, Elsevier, vol. 25(9), pages 1789-1804, September.
    4. Nicholas Barberis & Ming Huang, 2006. "The Loss Aversion / Narrow Framing Approach to the Equity Premium Puzzle," NBER Working Papers 12378, National Bureau of Economic Research, Inc.
    5. Nicholas Barberis & Ming Huang & Tano Santos, 2001. "Prospect Theory and Asset Prices," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 116(1), pages 1-53.
    Full references (including those not matched with items on IDEAS)

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    Keywords

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    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • E27 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Forecasting and Simulation: Models and Applications

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