Prospect Theory and Mean-Variance Analysis
Review of Financial Studies
2004
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.
- DOI
- 10.1093/rfs/hhg062
- Volume
- 17 (4)
- Pages
- 1015-1041
- Language
- en
- Export
- BibTeX
- Sources
- openalex crossref