Discrete-time behavioral portfolio selection under cumulative prospect theory

Yun Shi, Xiangyu Cui and Duan Li

Journal of Economic Dynamics and Control, 2015, vol. 61, issue C, 283-302

Abstract: We formulate and study three multi-period behavioral portfolio selection models under cumulative prospect theory: (i) S-shaped utility maximization without probability weighting in a market with one risky asset; (ii) S-shaped utility maximization without probability weighting in a market with multiple risky assets which follow a joint elliptical distribution; and (iii) S-shaped utility maximization with inverse-S-shaped probability weighting in a market with one risky asset. For the first two time consistent models, we identify the well-posedness conditions and derive the semi-analytical optimal policies. For the third time inconsistent model, we assume that the investor is aware of the time inconsistency but is unable to commit to his initial plan of action. Then, we reformulate the model into an intrapersonal game model and derive the semi-analytical subgame perfect Nash equilibrium (time consistent) policy under well-posedness condition. All the three policies take a piecewise linear feedback form. Our analysis of the three models not only partially explains the well documented phenomena of non-participation puzzle and horizon effect, but also extends the two fund separation theorem into multi-period S-shaped utility setting and pushes forward the study on time inconsistency issue incurred by probability weighting.

Keywords: Multi-period portfolio selection; S-shaped utility; Probability weighting; Time consistent policy; Two-fund separation; Non-participation puzzle and horizon effect (search for similar items in EconPapers)
JEL-codes: D03 G11 (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (10)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:61:y:2015:i:c:p:283-302

DOI: 10.1016/j.jedc.2015.10.002

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