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Dynamic Portfolio Allocation, the Dual Theory of Choice and Probability Distortion Functions

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  • Hamada, Mahmoud
  • Sherris, Michael
  • Hoek, John van der

Abstract

Standard optimal portfolio choice models assume that investors maximise the expected utility of their future outcomes. However, behaviour which is inconsistent with the expected utility theory has often been observed. In a discrete time setting, we provide a formal treatment of risk measures based on distortion functions that are consistent with Yaari’s dual (non-expected utility) theory of choice (1987), and set out a general layout for portfolio optimisation in this non-expected utility framework using the risk neutral computational approach. As an application, we consider two particular risk measures. The first one is based on the PH-transform and treats the upside and downside of the risk differently. The second one, introduced by Wang (2000) uses a probability distortion operator based on the cumulative normal distribution function. Both risk measures rank-order prospects and apply a distortion function to the entire vector of probabilities.

Suggested Citation

  • Hamada, Mahmoud & Sherris, Michael & Hoek, John van der, 2006. "Dynamic Portfolio Allocation, the Dual Theory of Choice and Probability Distortion Functions," ASTIN Bulletin, Cambridge University Press, vol. 36(1), pages 187-217, May.
    • Handle: RePEc:cup:astinb:v:36:y:2006:i:01:p:187-217_01
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    Cited by:

    1. Dominique Guegan & Bertrand Hassani & Kehan Li, 2017. "An alternative class of distortion operators alternative tools to generate asymmetrical multimodal distributions," Documents de travail du Centre d'Economie de la Sorbonne 17030, Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne.
    2. Bertrand K. Hassani & Wei Yang, 2016. "The Lila distribution and its applications in risk modelling," Documents de travail du Centre d'Economie de la Sorbonne 16068, Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne.
    3. Dominique Guegan & Bertrand Hassani & Kehan Li, 2017. "An alternative class of distortion operators," Post-Print halshs-01543251, HAL.
    4. Dominique Guegan & Bertrand Hassani & Kehan Li, 2017. "An alternative class of distortion operators," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-01543251, HAL.
    5. Bertrand K. Hassani & Wei Yang, 2016. "The Lila distribution and its applications in risk modelling," Post-Print halshs-01400186, HAL.
    6. Massimiliano Barbi & Silvia Romagnoli, 2016. "Optimal hedge ratio under a subjective re-weighting of the original measure," Applied Economics, Taylor & Francis Journals, vol. 48(14), pages 1271-1280, March.

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