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Goal-Based Investing with Cumulative Prospect Theory and Satisficing Behavior

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  • Enrico G. De Giorgi

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Abstract

This paper presents a time-continuous goal-based portfolio selection model with cumulative prospect theory preferences and satisficing behavior, where investors optimally split their wealth among several investment goals at different horizons. The paper extends the model of Berkelaar, Kouwenberg and Post (2004) to account for multiple-goals. We show that when the discounted values of all target wealths is not too high relative to the initial wealth (i.e., goals are not too ambitious), investors mainly invest to reach short-term investment goals and adopt safe investment strategies for this purpose. However, when goals are very ambitious, they put a high proportion of their wealth in long-term goals and adopt aggressive investment strategies with high leverage to reach short-term goals and the overall investment strategy also displays high leverage. High incentives to reach ambitious shortterm goals (high target returns) and the consequent excessive leverage have been identified as causes for the global financial crisis erupted in 2008.

Suggested Citation

  • Enrico G. De Giorgi, 2009. "Goal-Based Investing with Cumulative Prospect Theory and Satisficing Behavior," University of St. Gallen Department of Economics working paper series 2009 2009-22, Department of Economics, University of St. Gallen.
  • Handle: RePEc:usg:dp2009:2009-22
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    File URL: http://ux-tauri.unisg.ch/RePEc/usg/dp2009/DP-0922-Gi.pdf
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    References listed on IDEAS

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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. 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.
    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. Nicholas Barberis & Ming Huang, 2008. "Stocks as Lotteries: The Implications of Probability Weighting for Security Prices," American Economic Review, American Economic Association, vol. 98(5), pages 2066-2100, December.
    5. Richard H. Thaler, 2008. "Mental Accounting and Consumer Choice," Marketing Science, INFORMS, vol. 27(1), pages 15-25, 01-02.
    6. David B. Brown & Melvyn Sim, 2009. "Satisficing Measures for Analysis of Risky Positions," Management Science, INFORMS, vol. 55(1), pages 71-84, January.
    7. Nicholas Barberis, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," Journal of Finance, American Finance Association, vol. 56(4), pages 1247-1292, August.
    8. Enrico G. De Giorgi & Shane Legg, 2009. "Portfolio Selection with Narrow Framing: Probability Weighting Matters," University of St. Gallen Department of Economics working paper series 2009 2009-12, Department of Economics, University of St. Gallen.
    9. Shefrin, Hersh & Statman, Meir, 2000. "Behavioral Portfolio Theory," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(02), pages 127-151, June.
    10. Nishant Dass & Massimo Massa & Rajdeep Patgiri, 2008. "Mutual Funds and Bubbles: The Surprising Role of Contractual Incentives," Review of Financial Studies, Society for Financial Studies, vol. 21(1), pages 51-99, January.
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    More about this item

    Keywords

    behavioral finance; portfolio selection; mental accounting; narrow framing; cumulative prospect theory; satisficing; loss aversion; goal-based approach;

    JEL classification:

    • D10 - Microeconomics - - Household Behavior - - - General
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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