Static Portfolio Choice under Cumulative Prospect Theory

Carole Bernard and Mario Ghossoub

MPRA Paper from University Library of Munich, Germany

Abstract: We derive the optimal portfolio choice for an investor who behaves according to Cumulative Prospect Theory. The study is done in a one-period economy with one risk-free asset and one risky asset, and the reference point corresponds to the terminal wealth arising when the entire initial wealth is invested into the risk-free asset. When it exists, the optimal holding is a function of a generalized Omega measure of the distribution of the excess return on the risky asset over the risk-free rate. It conceptually resembles Merton’s optimal holding for a CRRA expected-utility maximizer. We derive some properties of the optimal holding and illustrate our results using a simple example where the excess return has a skew-normal distribution. In particular, we show how a Cumulative Prospect Theory investor is highly sensitive to the skewness of the excess return on the risky asset. In the model we adopt, with a piecewise-power value function with different shape parameters, loss aversion might be violated for reasons that are now well-understood in the literature. Nevertheless, we argue, on purely behavioral grounds, that this violation is acceptable.

Keywords: Cumulative Prospect Theory; Portfolio Choice; Behavioral Finance; Omega Measure. (search for similar items in EconPapers)
JEL-codes: D81 G11 (search for similar items in EconPapers)
Date: 2009-04-29
New Economics Papers: this item is included in nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (42)

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