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Prospect theory and asset allocation

Author

Listed:
  • Fortin, Ines

    (Macroeconomics and Business Cycles, Institute for Advanced Studies, Vienna, Austria)

  • Hlouskova, Jaroslava

    (Macroeconomics and Business Cycles, Institute for Advanced Studies, Vienna, Austria and Department of Economics, Faculty of National Economy, University of Economics in Bratislava, Slovak Republic)

Abstract
We study the asset allocation of an investor with prospect theory (PT) preferences. First, we solve analytically the two-asset problem of the PT investor for one risk-free and one risky asset and find that loss aversion and the reference return affect differently less ambitious investors and more ambitious investors. Second, we empirically investigate the performance of a PT portfolio when diversifying among a stock market index, a government bond and gold, in Europe and the US. We focus on investors with PT preferences under different scenarios regarding the reference return and the degree of loss aversion and compare their portfolio performance with the performance of investors under CVaR, risk neutral, linear loss averse and in particular mean-variance (MV) preferences. We find that, in the US, PT portfolios signiffcantly outperform (in terms of returns) mean-variance portfolios in the majority of cases. Also with respect to riskadjusted performance, PT investment outperforms MV investment in the US. Similar results, however, can not be observed in Europe. Finally, we analyze asymmetric effects along economic uncertainty and observe that PT investment leads to higher returns than MV investment in times of larger economic uncertainty, especially in the US.

Suggested Citation

  • Fortin, Ines & Hlouskova, Jaroslava, 2022. "Prospect theory and asset allocation," IHS Working Paper Series 42, Institute for Advanced Studies.
    • Handle: RePEc:ihs:ihswps:42
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    File URL: https://irihs.ihs.ac.at/id/eprint/6205
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    References listed on IDEAS

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    More about this item

    Keywords

    prospect theory; loss aversion; portfolio allocation; mean-variance portfolios; investment strategy;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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