Testing dominant theories and assumptions in behavioral finance

Moawia Alghalith, Christos Floros and Marla Dukharan

Journal of Risk Finance, 2012, vol. 13, issue 3, 262-268

Abstract: Purpose - The purpose of this paper is to empirically test dominant theories and assumptions in behavioral finance, using data from the Standard & Poor's 500 index. Design/methodology/approach - The empirical analysis has three parts: to test the assumption of risk aversion; to examine the dominant theory that the optimal portfolio depends on risk preferences; and to test prospect theory that decision makers prefer certain outcomes over probable outcomes. Finally, an alternative model to test prospect theory is introduced. Findings - The proposed model is more flexible than prospect theory since it does not a priori assume what value of the portfolio induces risk aversion/seeking, while it does not a priori preclude linear preferences. Empirical results show that: investors are risk seeking; a change in the sign of preferences does not necessarily imply a change in the sign of wealth/return and vice versa; and the optimal portfolio does not depend on preferences. Practical implications - These findings are helpful to risk managers dealing with models of behavioural finance. Originality/value - The contribution of this paper is that it successfully tests fundamental theories and assumptions in behavioral finance by providing a better alternative to prospect theory in several ways.

Keywords: Behavioural economics; Investors; Expectation; Financial forecasting; Risk aversion; Dominant theory; Prospect theory; S&P500 (search for similar items in EconPapers)
Date: 2012
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Persistent link: https://EconPapers.repec.org/RePEc:eme:jrfpps:15265941211229262

DOI: 10.1108/15265941211229262

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