Prospect theory and asset allocation

Ines Fortin and Jaroslava Hlouskova
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Ines Fortin: Macroeconomics and Business Cycles, Institute for Advanced Studies, Vienna, Austria

No 42, IHS Working Paper Series from Institute for Advanced Studies

Abstract: We study the asset allocation of an investor with prospect theory (PT) preferences. First, we solve analytically the two-asset problem of the PT investor for one risk-free and one risky asset and find that loss aversion and the reference return affect differently less ambitious investors and more ambitious investors. Second, we empirically investigate the performance of a PT portfolio when diversifying among a stock market index, a government bond and gold, in Europe and the US. We focus on investors with PT preferences under different scenarios regarding the reference return and the degree of loss aversion and compare their portfolio performance with the performance of investors under CVaR, risk neutral, linear loss averse and in particular mean-variance (MV) preferences. We find that, in the US, PT portfolios signiffcantly outperform (in terms of returns) mean-variance portfolios in the majority of cases. Also with respect to riskadjusted performance, PT investment outperforms MV investment in the US. Similar results, however, can not be observed in Europe. Finally, we analyze asymmetric effects along economic uncertainty and observe that PT investment leads to higher returns than MV investment in times of larger economic uncertainty, especially in the US.

Keywords: prospect theory; loss aversion; portfolio allocation; mean-variance portfolios; investment strategy (search for similar items in EconPapers)
JEL-codes: D81 G02 G11 G15 (search for similar items in EconPapers)
Pages: 59 pages
Date: 2022-12
New Economics Papers: this item is included in nep-cbe, nep-rmg and nep-upt
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https://irihs.ihs.ac.at/id/eprint/6205 First version, 2022 (application/pdf)

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Journal Article: Prospect theory and asset allocation (2024)
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