|fulltext etc.||no fulltext attached|
The prospect theory of Kahneman and Tversky (in Econometrica 47(2),
263–291, 1979) and the cumulative prospect theory of Tversky
and Kahneman (in J. Risk uncertainty 5, 297–323, 1992) are
descriptive models for decision making that summarize several
violations of the expected utility theory. This paper gives a survey
of applications of prospect theory to the portfolio choice problem
and the implications for asset pricing. We demonstrate that prospect
theory (and similarly cumulative prospect theory) has to be
re-modelled if one wants to apply it to portfolio selection. We
suggest replacing the piecewise power value function of Tversky and
Kahneman (in J. Risk uncertainty 5, 297–323, 1992) with a
piecewise negative exponential value function. This latter
functional form is still compatible with laboratory experiments but
it has the following advantages over and above Tversky and
Kahneman’s piecewise power function:
1. The Bernoulli Paradox does not arise for lotteries with finite expected value.
2. No infinite leverage/robustness problem arises.
3. CAPM-equilibria with heterogeneous investors and prospect utility do exist.
4. It is able to simultaneously resolve the following asset pricing puzzles: the equity premium, the value and the size puzzle.
In contrast to the piecewise power value function it is able to explain the disposition effect.
Resolving these problems of prospect theory we show how it can be combined with mean–variance portfolio theory.
|kind of paper||journal article|
|date of appearance||1-9-2006|
|journal||Financial Markets and Portfolio Management|
|volume of journal||20|
|number of issue||3|
|citation||De Giorgi, E., & Hens, T. (2006). Making Prospect Theory Fit for Finance. Financial Markets and Portfolio Management, 20(3), 339-360.|