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Portfolio Selection Optimization under Cumulative Prospect Theory – a parameter sensibility analysis

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  • Luis A.G. Coelho

    (CEFAGE-UE and Management Department, Évora University)

Abstract

The Cumulative Prospect Theory (CPT) is one of the most popular theories for evaluating the behavior of decision makers in the context of risk and uncertainty. This theory emerged as a generalization of the Expected Utility Theory (EUT) and being a relatively recent theory, its application has been somewhat reduced, especially when linked to optimization models. This paper intends to analyze the behavior of CPT, with a power value function and a two-parameter probability weighting function, as an objective function of a portfolio selection model. The parameterization of the objective function parameters allows us to analyze the composition of portfolios such as loss aversion, risk aversion in gains and risk preference in the range of losses. The results suggest that loss aversion and risk aversion in gains lead to the choice of portfolios with lower profitability and variability and that the risk preference in losses leads to the choice of portfolios with higher profitability and variability. The results are also compared with those obtained with EUT, and allow us to conclude that CPT leads to more diversified solutions which are therefore more easily adjusted to the investors’ behavioral profile.

Suggested Citation

  • Luis A.G. Coelho, 2014. "Portfolio Selection Optimization under Cumulative Prospect Theory – a parameter sensibility analysis," CEFAGE-UE Working Papers 2014_06, University of Evora, CEFAGE-UE (Portugal).
    • Handle: RePEc:cfe:wpcefa:2014_06
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    References listed on IDEAS

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    Cited by:

    1. Chao Gong & Chunhui Xu & Ji Wang, 2018. "An Efficient Adaptive Real Coded Genetic Algorithm to Solve the Portfolio Choice Problem Under Cumulative Prospect Theory," Computational Economics, Springer;Society for Computational Economics, vol. 52(1), pages 227-252, June.
    2. Beatrice D. Simo-Kengne & Kofi A. Ababio & Jules Mba & Ur Koumba, 2018. "Behavioral portfolio selection and optimization: an application to international stocks," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 32(3), pages 311-328, August.

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    More about this item

    Keywords

    Cumulative Prospect Theory; Portfolio Selection; Loss Aversion; Risk Aversion; Expected Utility.;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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