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Prospect Theory and Mean-Variance Analysis

Haim Levy and Moshe Levy ()

Chapter 9 in Handbook of the Fundamentals of Financial Decision Making:In 2 Parts, 2013, pp 149-175 from World Scientific Publishing Co. Pte. Ltd.

Abstract: The experimental results of prospect theory (PT) reveal suggest that investors make decisions based on change of wealth rather than total wealth, that preference 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 PTefficient portfolios…

Keywords: Financial Decision Making; Asset Pricing; Prospect Theory; Utility Theory; Risk Aversion; Static Portfolio Theory; Stochastic Dominance; Dynamic Modeling; Dynamic Portfolio Theory; Tactical Asset Allocation; Kelly Strategy; Capital Growth (search for similar items in EconPapers)
Date: 2013
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