Prospect Theory and Mean-Variance Analysis

Haim Levy

The Review of Financial Studies, 2004, vol. 17, issue 4, 1015-1041

Abstract: The experimental results of prospect theory (PT) reveal suggest that investors make decisions based on change of wealth rather than total wealth, that preferences are S-shaped with a risk-seeking segment, and that probabilities are subjectively distorted. This article shows that while PT's findings are in sharp contradiction to the foundations of mean-variance (MV) analysis, counterintuitively, when diversification between assets is allowed, the MV and PT-efficient sets almost coincide. Thus one can employ the MV optimization algorithm to construct PT-efficient portfolios. Copyright 2004, Oxford University Press.

Date: 2004
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